Finance term
Default Interest Rate
Also known as: penalty interest rate, default rate
Definition
A default interest rate is a higher interest rate automatically triggered when a borrower defaults on a loan. Typically prime + 3–7%, it compensates the lender for increased risk and incentivizes cure. State usury laws may cap default rates even on commercial loans.
Detailed explanation
Most commercial loan agreements contain a default interest provision: if the borrower misses a payment, violates a covenant, or otherwise defaults, the interest rate automatically steps up — often by 2–5 percentage points above the non-default rate. This increased rate applies from the date of default (or sometimes retroactively from origination) until the default is cured or the loan is repaid.
The legal basis for default interest is compensation for increased risk and cost. When a borrower defaults, the lender faces higher monitoring costs, collection costs, potential litigation, and increased credit risk. The default rate is designed to compensate for these costs and to create a strong financial incentive for the borrower to cure the default quickly.
State usury laws may limit default interest rates even on commercial loans in some jurisdictions, though commercial loan usury protections are much weaker than consumer protections. Some states have specific caps on default rate step-ups (e.g., maximum 5% above contract rate). Lenders in multiple states typically include choice-of-law provisions selecting states with more favorable usury treatment.
For borrowers, default interest is one of the most expensive possible outcomes of a financial distress situation. A loan at 8% that triggers a 15% default rate doubles the interest cost precisely when the business is least able to afford it. Proactive communication with lenders before default — and use of forbearance agreements — can avoid default interest while working through temporary cash flow problems.
◈ Worked example
- Loan at 7% interest rate with default rate provision of prime + 5%. Prime = 8.5%. Default rate = 13.5% — 6.5 percentage points above contract rate. On a $1M balance, default interest costs $65,000 more per year than non-default rate.
- SBA 7(a) loan: SBA regulations limit the amount lenders can charge above the non-default rate and require 60-day written notice before triggering default remedies. This provides borrowers meaningful cure window before default interest accrues.
- Commercial real estate loan defaults: many CRE loans have default rates of 5% above the non-default rate, plus late fees. Combined cost of default on a $2M CRE loan at 6.5% non-default / 11.5% default = $100K/year additional cost — powerful incentive to cure or negotiate.
Common questions
The most-asked questions about Default Interest Rate — answered straightforwardly.
When does a default interest rate begin accruing? +
Most loan agreements specify the default rate accrues from the date of default event (missed payment date, covenant violation date). Some agreements allow retroactive application from loan origination upon certain defaults (called 'springing' default interest). Review your loan agreement — the effective date of default rate accrual determines how much additional cost you face and shapes workout negotiations.
Can I negotiate the default interest rate in my loan agreement? +
Yes, particularly on larger commercial loans. A 'no default interest' provision (rare), a lower step-up (2% instead of 5%), or a longer grace period before default interest triggers are all negotiable at origination. Borrowers with strong credit profiles have more leverage to negotiate these terms. On SBA and government-guaranteed loans, the terms are more standardized.
Does curing a default stop the default interest rate? +
Generally yes — once a default is cured (missed payment made, covenant violation remedied within the cure period), the interest rate reverts to the non-default contract rate going forward. However, the lender may be entitled to keep the default interest that accrued during the default period even after cure. Review your loan agreement for the specific mechanics.
Further reading
This glossary entry is educational content. ClearValue Lending is a business & personal financing platform — not a lender, broker, or financial advisor. Specific product terms vary by lender; verify with the lender or issuer before applying. See privacy policy.
https://clearvaluelending.com/glossary/default-interest-rate