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One of the most important clauses in a loan agreement is the interest clause. This article sets out how to calculate interest and when you (as the borrower) must pay it.

Interest

The lender may or may not require the borrower to pay interest. The loan agreement should state whether or not interest is payable. If interest is payable:

  • it will be calculated on the amount outstanding (i.e. on the amount of principal that has not been repaid to date);
  • it will be calculated at an agreed interest rate. This should be specified in the loan agreement. The interest could be an agreed fixed rate (e.g. 5%) or a floating or variable rate (i.e. the interest rate is linked to a benchmark rate which might change every day, month or quarter); and
  • it will be payable on agreed dates. The interest payment date could be monthly, according to a repayment schedule, or at the end of the term. The interest payment dates should be specified in the loan agreement.

Default Interest

When making a loan agreement, you should consider whether or not default interest should be payable under the agreement. If default interest applies and you (the borrower) do not pay interest on or before the relevant interest payment date, interest will be payable at a default rate. The default interest rate is usually agreed upon upfront and should be specified within the interest clause of the loan agreement. It is often the interest rate plus an additional 1-2% per annum.

Additionally, if you (the borrower) are late in making principal repayments, you might have to pay interest at the default rate on that unpaid amount.

Calculation of Interest

The loan agreement should set out how to calculate interest. Some typical clauses include the following:

  • interest will accrue daily.” This means that an additional amount of interest becomes owing each day. Usually, interest is calculated only on the principal amount outstanding. This is the amount of money which the lender has lent to the borrower). However, in some cases, interest may be capitalised and form part of the principal. Hence, interest will be calculated on this aggregated amount;
  • 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.” This means interest will start being calculated from the time when the lender lends money to the borrower, and until the borrower has repaid all money it owes (including interest); and
  • interest will be calculated on the actual number of days elapsed on the basis of a 365-day year.” Most interest rates are expressed as a rate per annum (i.e. per year). Therefore, the rate needs to be divided, depending on the time that has elapsed.

If you see this type of wording in your loan agreement, this is how you should calculate the interest rate that will apply for one day:

If the rate of interest is 5% per annum: 5% x 1/365 = 0.014%

Capitalisation

As a borrower, you 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 you can skip an interest payment, but you will still have to pay the interest, albeit at a later date.

Your lender can add the interest charge to your loan balance. This aggregate balance (the loan amount plus the capitalised interest) will be the amount that interest is calculated on. As your loan balance increases, so too do its future interest charges. Therefore, capitalising interest can become very costly for you (as the borrower). But it means that you will be able to keep some of the cash you would otherwise have to use to pay interest. You can use the cash in other ways (or may already have!), for example for business expenses.

Key Takeaways

There are many important clauses in a loan agreement, including the interest clause. We have already explored some of them with you in part 1 and part 2 of our loan agreement series.

To find out more about loan agreements, contact LegalVision’s finance law specialists on 1300 544 755.

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