An $85,000 collection claim arrives in our office. The invoices are several months past due, and the creditor’s statement includes thousands of dollars in interest, compounded at 2% per month.
There’s just one problem. Can we actually collect it? Charging interest on past-due commercial accounts may seem relatively straightforward. A customer pays late, interest is added, and the balance continues to grow until payment is received. Unfortunately, it is not always that simple.
Interest and late-charge laws can vary considerably from state to state, and the enforceability of these charges may depend upon the contract, the nature of the transaction, and even which state’s law applies.
Here are six points credit professionals should keep in mind.
1. Make Sure the Interest Provision Is Part of the Agreement
The strongest position is to establish the interest or late-charge provision before the transaction begins. The provision might appear in a credit application, sales agreement, purchase order, terms and conditions, or another contractual document agreed upon by the customer.
A statement such as, “Past-due balances are subject to a late charge of 1.5% per month,” may provide a much stronger basis for recovery when the customer has agreed to it in advance. Simply adding an interest charge for the first time on an invoice after the transaction has already occurred can create questions about whether the customer ever agreed to pay it.
2. Determine Which State’s Law Applies
Your company may be located in Illinois, your customer may be in California, and the products may have been shipped from another state entirely. Which law governs? Many contracts contain a “governing law” provision specifying which state’s law will apply. Without one, the answer can become considerably more complicated.
Because state laws regarding interest, late fees, and usury differ, companies doing business across state lines should have their terms reviewed by legal counsel.
3. Interest, Finance Charges, and Late Fees Are Not Necessarily the Same
Companies sometimes use the terms interest, finance charge, service charge, and late fee interchangeably. Legally, however, those terms may not always mean the same thing.
How a charge is characterized can affect whether certain state limitations apply and whether the charge can ultimately be enforced. For that reason, the terminology in the agreement should be deliberate rather than simply copied from another company’s credit application.
4. Don’t Assume 1.5% Per Month Is Automatically Permissible
A monthly charge of 1.5% is very “common” in commercial credit. That equals 18% annually before considering any compounding. But “common” does not necessarily mean universally permissible.
Different states may impose different limitations, exemptions, or rules depending upon whether the obligation involves a corporation, a commercial transaction, a loan, or another type of credit arrangement. There is no single interest rate that can safely be assumed to apply to every commercial transaction in every state.
5. Make Sure Your Accounting System Matches Your Agreement
Even when interest is legally permissible, it still needs to be calculated correctly. Does interest begin the day after the invoice due date? Is it calculated monthly or daily? Is it simple interest or compounded? How are partial payments applied?
Credit departments should periodically test their accounting software to make sure the system is calculating charges in accordance with the company’s contractual terms. A computer-generated calculation is not necessarily a correct calculation.
6. Remember That Interest Is Also a Collection Tool
From a collection standpoint, properly assessed interest can have considerable value.
First, it gives customers an additional incentive to pay invoices on time.
Second, it can provide negotiating room when resolving a delinquent account.
For example, if a customer owes $50,000 plus $6,000 in properly assessed interest, agreeing to waive the interest in exchange for immediate payment of the full principal can create a meaningful settlement incentive. The debtor believes it has received a $6,000 concession, while the creditor receives 100% of the original invoice balance.
Not every company chooses to assess interest, and there can be sound business reasons for deciding not to do so. Customer relationships, competition, future sales opportunities, and the amount of the outstanding balance may all factor into that decision.
The important point is that charging interest should not simply be an automatic accounting function. It should be a deliberate credit policy decision supported by clear contractual language, accurate calculations, and an understanding of the law that applies to the transaction.
Interest and late-charge laws vary by state and by transaction. Companies should consult qualified legal counsel regarding the enforceability of their specific contractual terms.
Your thoughts and comments (nseiverd@cmiweb.com) are most welcome!
Nancy Seiverd, President
CMI Credit Mediators, Inc.
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