Let’s say you provided a loan to a borrower. The borrower had been paying as scheduled but now comes to you and says they are having a cash flow problem. The borrower asks for a temporary pause on payments and says they will start making payments again after that period ends at a higher interest. The original payment terms accounted for 10% interest. Can you now charge interest on top of interest? Charging interest like this is called “compound interest.” Compound interest is the addition of interest to the principal sum of a loan or interest on principal plus interest. Simple interest, however, is interest on the principal.
The main concern any lender would have in this situation is whether the loan would be considered “usurious.” Usury is the practice of lending money at an unreasonably high rate of interest.
Normally, a lender could be sued for civil usury under a civil claim, if the interest is more than 16% per year. A lender could be charged with a felony for criminal usury if the interest on the loan exceeds 25% interest per year.
New York’s Stance on Compound Interest
When charging compound interest, a lender could increase the effective interest rate on a loan to a possibly usurious level. Therefore, New York limits lenders’ abilities to collect compound interest on a loan. Foremost, New York forbids compound interest on most loans that are under $250,000 with some exceptions:
- Loans of $5,000 or more secured by certain Uniform Commercial Code documents.
- Business Loans of $100,000 or more secured under the Uniform Commercial Code with a rate at or below the prime rate plus 8% per annum.
New York also forbids compound interest on any loan secured by a one or two-family owner-occupied residence.
If a lender charges compound interest and the effective interest rate is at or below the usury ceiling, the lender must refund the “compounded” part of the interest but not the other interest already paid. If, however, the effective rate exceeds the usury ceiling, then more severe penalties will apply.
Loan considered usurious become wholly void. The lender will forfeit all principal and interest, and the borrower can also recover the usurious portion of interest previously paid. However, if the lender is a savings bank or certain institutional lender, the lender forfeits all interest, but not the principal.
As also stated, if the effective date is more than 25% per annum, then the loan is criminally usurious. Any lender that knowingly collects criminally usurious interest commits a felony.
An interest rate above the civil usury rate per annum is not considered usurious if the loan or obligation includes a provision that provides for interest at a rate that locks in after the borrower defaults. The New York courts’ reasoning is that the interest rate in that scenario does not constitute a loan or a forbearance, but rather involved interest to be paid based upon a contingency within the control of the borrower. The borrower could have avoided the imposition of the new interest rate simply by paying timely when agreed. By defaulting, the borrower’s own actions caused the imposition of the higher rate.
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