One of the most common misunderstood issues our firm comes across is the basic late charge. Lenders will request that loan documents include a 15% percent late charge with a 5-day grace period, or a late charge on the entire principal balance when a maturity balloon payment is not paid. Lenders are often surprised to find out that there are restrictions on the amount of late charge and the minimum grace period required before a late charge can be assessed.
This article addresses common misconceptions and limitations of late charges.
Are late charges permissible?
This may appear to be a silly question. Most promissory notes include a late charge and late charges are the rule, not the exception. Late charges are essentially a contract provision for liquidated damages. The concept behind a liquidated damages clause is that the potential damages to a lender are difficult to determine at the time of making the loan. For example, if a payment is not paid on time, the lender will need to pay a loan servicer or an employee to follow up with the borrower. The expense to do so is not always clear and ascertainable at the outset of the transaction, but there is necessarily an expense.
Under California law, the late charge must bear a reasonable relationship to the probable loss of the lender resulting from the late payment.[1] An unreasonable late charge is unenforceable as a penalty that punishes the borrower. California law prohibits punitive damages in contracts.[2] Since the purpose of a late charge is to compensate the lender for any damages suffered due to the late payment, a late charge that is out of line with that compensation is interpreted as existing to punish the borrower for nonperformance and is therefore unenforceable.
Statutory limitations on late charges
The type of license under which a lender originates a loan will determine whether the loan has a statutory restriction on the late charge. Below is a sampling of statutory restrictions of late charges:
Default Statutory Limitation (non-licensed loans)
When the loan is not originated through any type of license, California law prohibits a late charge in excess of the greater of 6% of the installment payment due, or $5. Payments cannot be considered late until at least 10 days following the due date of the installment payment.[3]
Bureau of Real Estate License Originated Loans
If a licensed California broker arranges a loan to a private investor or directly makes a loan which loan is secured by a 1-4 family residential property, California code prohibits a late charge in excess of the greater of 10% of the installment payment due, or $5. Payments cannot be considered late until at least 10 days following the due date of the installment payment. The maximum late charge permitted on any balloon payment is the maximum late charge that could be assessed on the largest single monthly installment due and cannot be assessed on the entire balloon payment.[4]
Credit Union Loans
All loans, regardless of collateral type originated by a credit union share the same limitations as broker-originated loans, 10% on the installment due with a minimum 10-day grace period.[5]
FHA/VA Loans
For FHA/VA loans, the late charge cannot exceed 4% of the delinquent payment and cannot be collected unless a payment is more than 15 days late.[6]
National Banks
National banks may impose any late charge on California residents permitted by the law of the bank’s home state, even though the amount exceeds the legal limit in California.[7]
Out-of-State Loans
Most states regulate and limit late charges. For example, Colorado prohibits a late charge in excess of 5%, which may only be assessed after a 10-day grace period for certain consumer credit transactions.[8]
What if my transaction is not covered by a statutory limitation?
There may be instances in which a statutory restriction does not apply. For example, a loan that is arranged by a licensed BRE broker but secured by commercial real property or business purpose loans made by a licensed California Finance Lender.
When the late charges for a loan are not limited by statute, the Lender must still charge a fee that is reasonable in relation to the harms incurred by the Lender. The courts in California have determined that the following late charges were unenforceable as penalties which bore no reasonable relationship to the harm incurred by Lender.
Garrett v. Coast & Southern Fed. Sav. & Loan Assn. [9]
The California Supreme Court held that a 2% late charge assessed on the principal balance of the loan when a Borrower failed to pay the loan off at maturity was punitive in character and not reasonably calculated to compensate the injured lender. The late charge provision was held to be void, and the Court remanded for an assessment of the actual damages sustained by the lender.
Los Angeles City School Dist. v. Landier Inv. Co. [10]
The California Court of Appeals stated that a late charge provision providing for a double payment would be unenforceable as a penalty.
Ridgley v. Topa Thrift & Loan. [11]
The California Supreme Court held that a late fee disguised as a prepayment penalty which was equal to six months’ interest, but only due if the borrower was late was an unenforceable penalty.
Poseidon Development, Inc. v. Woodland Lane Estates, LLC. [12]
The California Court of Appeals determined that a 10% late charge on any “installment” payments could not apply to the balloon payment, and only applied to monthly interest payments. Otherwise, it would have been an unenforceable penalty not rationally related to compensating the lender for the late payment. The Court reasoned that the administrative costs associated with collecting a late payment for a regular monthly late payment was $641.67, and the administrative costs to collect on a maturity default would not have been much greater yet resulted in a $77,641.67 penalty.
Other Considerations
Pyramiding of Late Charges
California code prohibits the practice of pyramiding late charges.[13] For example, if a borrower fails to make a timely payment in January, but makes the regular installment payment due in February, a lender cannot charge a late charge for February even though the payment received in February would be applied towards the January payment and the February installment payment would still be due.
Conclusion
All late charges must be reasonably related to the costs incurred by a lender even when a loan is not covered by a statutory restriction. In transactions where statutory restrictions did not apply, the California courts prohibited (i) late charges as low as 2% assessed on balloon payments, (ii) multiple months of interest charged upon a single late payment, and (iii) a double payment due when late. When determining a reasonable and enforceable late charge, lenders must be able to ultimately demonstrate the actual damages sustained by lenders, and not charge such a high late fee that could be interpreted as punishing the borrower.
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[1] California Civil Code § 1671
[2] California Civil Code § 3294
[3] California Civil Code § 2954.4
[4] California Business and Professions Code § 10242.5
[5] California Financial Code § 15001; California Civil Code 2954.5
[6] 12 U.S.C.A. §§ 1701 et. seq.; 38 U.S.C.A. §§3701 et seq..; 38 C.F.R. § 36.4311(c)
[7] 12 U.S.C.A.§ 85
[8] COLO. REV. STAT. ANN. § 5-2-203(1)
[9] 9 Cal. 3d 731, 511 (Cal. 1973)
[10] 177 Cal. App. 2d 744, (Cal. App. 2d Dist. 1960)
[11] 17 Cal. 4th 970, 953 (Cal. 1998)
[12] 152 Cal. App. 4th 1106, (Cal. App. 3d Dist. 2007)
[13] California Civil Code § 2954.4
