What is a default interest rate?

How the clause is written

The default rate usually sits in the interest section of the loan agreement or note, in a sentence along these lines: while an event of default exists, the obligations bear interest at the rate otherwise applicable plus an additional margin. Four details in that sentence decide what it will cost you, and they vary from agreement to agreement.

The trigger is an event of default as the agreement defines it, which is broader than most owners expect. Missing a payment is the obvious one. So are breaching a financial covenant, failing to deliver a compliance certificate on time, a material misstatement in the loan documents, a default on other debt through a cross-default, and in many agreements a change of control. Most of these come with a grace or cure period before they become events of default; the default rate generally starts after that.

Automatic or on notice

The distinction that matters most is whether the default rate applies by itself or only when the lender chooses. Many agreements split it. A missed payment or a bankruptcy filing starts default interest automatically, often only on the overdue amount for a missed payment. Every other event of default starts it only when the lender, or in a shared loan the required share of lenders, gives notice that it is electing the default rate.

The split exists because non-payment defaults range from serious to trivial. A late compliance certificate is technically an event of default in many agreements. A lender that charged default interest on the entire balance automatically for every late report would be charging it constantly, and most do not want to. Election by notice lets the lender reserve the default rate for defaults it considers real.

Check whether an election by notice can be backdated. Some agreements let the lender charge the default rate from the date the default occurred, not the date of the notice.

Default interest, late charges and acceleration are three different things

Lenders rarely accelerate over a covenant breach at a business that is still paying. They are far more likely to charge default interest, stop further draws on a line, and ask for a waiver or amendment on terms that suit them. The default rate is often the most immediate financial consequence of a breach, which is why it becomes part of the negotiation.

Why it matters in a covenant breach negotiation

Suppose a borrower's quarter-end compliance certificate shows a breached coverage covenant. The certificate goes in, the lender responds, and a waiver or amendment is agreed some months later. If the agreement allows default interest from the date of the breach, it has been accruing the whole time. On a balance of 2,000 with a default add-on that works out to 40 a year, four months of negotiation adds about 13 of extra interest, before any waiver fee.

That accrued amount is leverage. A lender may offer to waive the breach and forgive the accrued default interest in exchange for an amendment fee, a tighter covenant, more frequent reporting, a paydown, or a higher spread going forward. A borrower who understands the clause can make forgiving default interest an explicit part of the deal instead of discovering it on the next statement.

• Ask the lender, in writing, whether it has elected the default rate and from what date.
• Put the treatment of accrued default interest on the table in the first conversation, not the last.
• Consider whether an equity cure right lets you cure the breach before default interest starts.
• Remember that the default rate stops only when the default is cured or waived; an informal promise not to enforce does not end it.

What to do after a covenant breach covers the full set of options, including refinancing with a different lender.

Limits on the default rate

Default rates are not unlimited. State usury laws cap interest in some situations, and courts in some states will not enforce a default rate so high that it looks like a penalty rather than compensation for the lender's added risk. Bankruptcy courts apply their own rules. These are legal questions for your counsel, not something to rely on in a negotiation.

SBA loans have their own framework. SBA caps the rate a 7(a) lender may charge, by loan size, and the SBA maximum rate page sets out each tier. How a particular SBA lender's note treats a default, and whether a default rate applies at all, is a question to ask that lender before closing, not after a missed payment.

What to negotiate before you sign

The time to shape the default rate clause is when the credit agreement is drafted, while you still have alternatives. The most useful asks are narrow and specific:

• Default interest automatic only for payment defaults and bankruptcy, and only on overdue amounts for a missed payment.
• For every other event of default, default interest only on written notice, and only from the date of the notice.
• Grace and cure periods for reporting and covenant defaults before they become events of default.
• A clear statement that default interest ends on the date the default is cured or waived.

The better protection is not needing the clause. Transparent's financing model shows covenant headroom at every test date, so a covenant that sits too close to the projection is visible, and renegotiable, before closing rather than after the first breach. How we underwrite describes how the file is tested.