One of the most important clauses in a loan agreement is the interest clause. This sets out how and when interest and default interest (if applicable) are to be calculated and paid by the Borrower.
The parties will agree whether or not interest is payable on the loan. The loan agreement usually states whether or not interest is payable.
If interest is payable:
- it will be payable on the Loan (i.e. on the amount of Principal that has not been repaid to date) until it becomes due and owing;
- it will be payable at an agreed interest rate. This should be specified in the loan agreement; and
- it will be payable on agreed interest payment dates (often monthly). Again the interest payment dates should be specified in the loan agreement.
The parties will agree whether or not default interest should be payable under the loan agreement.
If default interest does apply then, if the borrower does not pay interest on or before the relevant interest payment date, interest will be payable at a default rate. The parties will agree on the default rate upfront and it should be specified in the loan agreement. It is often the interest rate plus an additional 1-2% per annum.
In addition, the borrower, on demand by the lender, has to pay interest on any money which is due and owing but remains unpaid at the default rate, until such money is paid in full.
Calculation of Interest
The loan agreement should set out how interest is to be calculated. Some typical clauses include the following:
- interest will accrue daily;
- interest will be calculated from and including the day when the money on which interest is payable becomes owing to the lender until but excluding the day of payment of that money; and
- interest will be calculated on the actual number of days elapsed on the basis of a 365 day year.
The parties may agree that the lender can capitalise any part of the interest which becomes due and payable and is not paid on its due date. This means that the borrower can skip an interest payment but it will still have to pay the interest, albeit at a later date. The lender adds the interest charge to the borrower’s loan balance so the borrower owes more and more as it capitalises. As the borrower’s loan balance increases so do its future interest charges. The key advantage to the borrower of this option is that it has the use of those funds for a greater period of time.
There are many important clauses in a loan agreement. We have already explored some of them with you in part 1 and part 2 of our loan agreement series, and will be exploring some of the other clauses over the coming weeks.
To find out more about loan agreements, or for any other finance law related matters, please contact us on 1300 544 755. One of our finance law specialists would be delighted to assist!