This article analyzes the purpose of late charge provisions in trust deed notes and their enforcement by carryback sellers and private lenders.

Unrelated penalties 

A seller carries back a note and trust deed on a sale involving any type of real estate. The note calls for a buyer to pay periodic installments by the first day of each month, called the payment due date. 

The note contains a late charge provision. Following the due date for a payment, it is agreed between the seller and buyer that a period of ten days is to pass during which a payment may be delivered before the seller may impose a late charge, called a grace period. If a payment is not received by the seller by the expiration of the grace period, the payment is then considered delinquent. 

When an installment becomes delinquent, the interest accruing at the note rate on the remaining principal balance will by agreement be increase 2% (200 basis points) as a late charge until the delinquency is cured, called a default rate. 

The seller does not receive an installment before it becomes delinquent. The seller makes a written demand on the buyer to pay the delinquent installment, together with an amount equal to the 2% additional interest on the entire principal balance. The additional interest accrues on a per diem basis between the expiration of the grace period and seller’s receipt of the delinquent installment. 

The buyer tenders the delinquent payment, but refuses to pay the late charge in the form of accrued interest on the loan balance at the 2% annual rate. The buyer claims the default rate provision is an invalid liquidated damages provision since the amount exceeds the out-of-pocket money losses the seller incurred due to the delinquency. 

The seller claims the late charge is valid and enforceable since the buyer agreed to the charge in the note and the actual costs of collection incurred by the seller are difficult to ascertain. 

Can the seller enforce the default rate late charge provision in the note?  

No! As a late charge, the amount is unreasonable and thus unenforceable. The provision is an attempt to impose a penalty due to the delinquency in a payment of a scheduled installment. The amount of the charge for the delinquency is based on a rate of interest accruing on the entire debt, not just interest on the amount of the delinquent principal and interest payment. Thus, the late charge is based on amounts owed, but not yet due or delinquent. 

For all notes secured by any type of real estate, a late charge provision calling for an interest rate calculated on the entire principal balance to ascertain the amount of the late charge due to the delinquency of a monthly installment, is a disguised penalty provision. 

Disguised penalty provisions are void and thus unenforceable. To be enforceable, the carryback seller’s compensation under a late charge provision is limited solely to his monetary losses caused by the delinquency in the payment. [Garrett v. Coast and Southern Federal Savings and Loan Association (1973) 9 C3d 731] 

Elements of a late charge 

To establish the right to enforce collection of a late charge, the following conditions must be met: 

  • a late charge provision exists in the note; 
  • a scheduled payment is delinquent; 
  • a notice of delinquency (NOD) is delivered to the payor demanding payment of the late charge; 
  • the dollar amount of the late charge is within the limits set by statutes (for money lenders) or reasonableness standards (for carryback sellers); and 
  • compliance with the accounting requirements imposed by statute. 

The failure of an owner to pay a late charge which is properly demanded by a seller on a delinquent payment is a non-material breach of the note and trust deed. As a result, failure to pay late charges cannot be the sole monetary basis for initiating a foreclosure. 

Distinctions exist in the treatment of late charges permitted for private lender loans as compared to charges permitted for seller carryback paper. For private lenders, late charges on loans secured by single family residences (SFRs) are treated differently than when they are secured by other types of property. Also, the amount of the late charge a private lender may impose is further controlled by whether or not the loan was made or arranged by a broker. 

The negotiation of late charges 

Late charge provisions are included in all notes used by institutional lenders. Late charge provisions sought by institutional lenders are generally non-negotiable, due primarily to established uniformities, such as ceilings set by statute or amounts demanded in the secondary mortgage money market. However, the inclusion of late charge provisions in notes carried back by sellers or originated by private lenders are negotiable. 

Before a late charge provision may be added to a note, the charge must first be negotiated and agreed to. When the late charge is agreed to as part of the carryback note provision in a purchase agreement, it is then proper for escrow to include the late charge provision in the note prepared for the buyer’s signature. 

The provision and the late charge amount 

For a late charge provision to be complete, it must include: 

  • the amount of the late charge; 
  • the span of any grace period following the due date before a payment becomes delinquent; and 
  • a requirement for notice from the trust deed holder to impose the late charge and make a demand for its payment. 

The amount of a late charge imposed on the delinquency of a payment on a debt secured by real estate, except private loans secured by an owner-occupied single family residence (SFR), must be reasonably related to money losses incurred by the creditor (carryback seller and non-SFR private lenders) due to the delinquency. [Calif. Civil Code §1671] 

While late charge provisions are triggered by the delinquency of a periodic payment or the final/balloon payment, the late charge agreed to is not automatically due. Unless the delinquency is immediately preceded or followed by a notice imposing the charge and demanding its payment, the charge is waived. [CC §2954.5] 

The dollar amount of monetary losses collectible as a late charge include: 

  • the actual out-of-pocket expenses incurred in a reasonable collection effort; and 
  • the lost use of the principal and interest (PI) portion of the delinquent payment. 

Money losses incurred in a reasonable effort to collect a late payment include the cost of forms, envelopes and postage for mailing the notice, and the time spent by individuals to do so prior to recording a notice of default (NOD). 

Even if the late charge provision is void as a dollar amount which is excessive and constitutes a financial windfall to the carryback seller or private lender, the buyer is still liable for the seller’s or lender’s actual money losses resulting from the delinquency. [Garrett, supra] 

When a scheduled payment is not received prior to its becoming delinquent, a late charge provision in an installment note properly calls for either:  

  • an additional one-time fixed fee stated as a dollar amount; or 
  • the accrual of interest on the amount of the delinquent PI payment. 

For example, a one-time late charge takes the form of a flat fee, such as $50.00, or a percentage of the monthly PI installment, such as 6%. Infrequently, a late charge is disguised as an unenforceable default interest rate charged on the entire principal, as presented in this article’s opening example. 

Fundamentally, any formula or percentage figure used to determine the amount of a one-time late charge is questionable. A lender is only entitled to reimbursement for his costs and efforts of collection. When a formula or percentage figure is used in larger loans to calculate the amount due, the issue of unjust enrichment arises. The same amount of time, effort and funds are expended in the collection of a delinquent payment on a $50,000 loan as are expended on a $500,000 loan, but use of the same formula or percentage for each imposes a hugely different dollar amount on the larger loan involved. [Garrett, supra] 

Late charge notice 

To collect a late charge for the delinquent payment on a note secured by any type of real estate, the carryback seller or private lender holding the note must notify the property owner of the charge and make a demand for its payment. 

Private lenders must give notice and make a demand for the late charge in a timely manner by use of either: 

  • a billing statement or notice sent for each payment prior to its due date stating the late charge amount and the date on which it will be incurred; or 
  • a written statement or notice of the late charge amount concurrent with or within ten days after mailing a notice to cure a delinquency. [CC §2954.5(a)] 

The notice of delinquency (NODq) or the billing statement, whichever is used, must include the exact amount of the late charge or the formula used to calculate the charge. [CC §2954.5(a)] 

If the private lender fails to enforce collection of the late charge for any delinquency by a notice and demand for its payment, the lender waives his right to collect a late charge on that payment. However, failure to comply with the late charge notice requirements on a delinquency does not waive the private lender’s right to enforce the late charge provision on future delinquencies. [CC §2954.5(e)] 

In regards to carryback notes, if, on receipt of a delinquent payment, the carryback seller fails to make a demand for payment of the late charge, he waives his right to collect a late charge on that installment. [Calif. Code of Civil Procedure §2076; CC §1501] 

However, after a carryback seller waives his right to collect by continually receiving delinquent payments and failing to impose late charges, he must give the buyer an advance notice of his intention to demand a late charge on future installments should they become delinquent. 

The right to enforce the grace period and late charge on future delinquencies must be reinstated by a timely notice of the beneficiaries intent to use the provision. A 30 day notice is considered timely if installments are due monthly. [In re Hein (9th Cir. 1986) 60 BR 769; CC §2954.5(b), (e)] 

Late charges on SFRs 

A private lender makes a loan to a homeowner secured by his single family residence (SFR). The note calls for monthly installments of principal and accrued interest (PI) to be paid on the first day of each month. The loan is not made or arranged by a broker. 

The note contains a late charge provision allowing: 

  • a ten day grace period after the due date for the lender to receive each monthly payment before it is delinquent; and 
  • a late charge of 6% of the delinquent PI installment on written notice and demand for its payment. 

A monthly payment is not received on or before the eleventh day of the month, the expiration of the ten day grace period. 

The lender sends the homeowner a written notice demanding payment of the delinquent installment and the agreed-to 6% late charge. 

The homeowner makes the delinquent payment but refuses to pay the late charge. 

Is the private lender’s demand for the late charge enforceable? 

Yes! The installment was not received by the expiration of the ten day grace period following the due date of the installment. Thus, it is delinquent and a late charge is collectible on notice and demand. 

Ten days is the minimum grace period allowed for a private lender secured by an owner-occupied SRF, even if the homeowner agrees to a shorter grace period, or no grace period is agreed to. [CC §2954.4(a),(b)] 

The late charge amount on a private lender loan which is not made or arranged by a broker and is secured by an owner- occupied SFR is limited to the greater of: 

  • 6% of the delinquent principal and interest installment; or 
  • $5. [CC §2954.4(a), (e)] 

What if the payment was post-marked as mailed within the grace period but was received by the lender after the grace period expired? 

Mailing the installment within the grace period does not qualify the payment as timely paid. The payment must be actually received by the carryback seller, lender or collection agent no later than the last day of the grace period and be immediately negotiable. [Cornwell v. Bank of America National Trust and Savings Association (1990) 224 CA3d 995] 

Conversely, the note may require the owner to tender the payment by employing a particular method of payment, such as by mail. Then the payment is considered received when the owner complies with the method of payment, such as placing the payment in the mail, even if the noteholder never receives it. [CC §1476] 

Made or arranged by brokers 

When a licensed real estate broker makes or arranges a loan, the 6% limit for late charges established for loans secured by owner- occupied single family residences (SFRs) does not apply. [CC §2954.4(e)] 

For private lender loans made or arranged by a real estate broker, called a brokered loan, and secured by any type of real estate, the late charge is limited to the greater of: 

  • 10% of the delinquent principal and interest payment; or 
  • $5. [Calif. Business and Professions Code 10242.5(a)] 

Also, if the private lender loan made or arranged by a broker contains a due date for a final/balloon payment, a late charge may be assessed on the final/balloon payment if it is not received within ten days after the due date. 

However, the amount of the late charge assessed on a delinquent final/balloon payment for a brokered loan is limited to the amount of the 10% late charge due (calculated) on regularly scheduled monthly installments. The late charge on a final/balloon payment for a brokered loan may be charged for each month the payment remains delinquent. In addition, interest at the note rate (or default rate) continues to accrue and be payable. [B & P C §10242.5(c)] 

Like an owner-occupied SFR loan, an installment on a private lender loan made or arranged by a broker on any type of property is not late if paid (received by the lender) within ten days after the installment is due. [B & P C §10242.5(b)] 

One charge per delinquency 

For a private lender loan secured by an owner-occupied single family residence (SFR), or one made or arranged by a broker and secured by any type of property, the private lender cannot charge more than one late charge per delinquent monthly installment, no matter how many months the payment remains delinquent. [CC §2954.4(a); B & P C §10242.5(b)] 

For example, a homeowner fails to make the January and February installments on a loan made by a private lender and secured by an owner- occupied SFR (regardless of whether the loan was arranged by a broker). 

The private lender charges the homeowner a late fee for each month a payment remains delinquent, demanding two late charges for the January payment and one for the February payment. 

The homeowner pays one installment in March before the grace period expires. 

The lender’s accounting applies the payment to the delinquent principal and accrued interest (PI) installment due in January, and demands payment of additional late charges for the failure to timely pay the February and March installments. 

However, the lender may only collect two late payment charges, no matter how many months pass before catching up the missed payments, one for the January installment and one for the February installment (both of which still remain unpaid), and none for March since the March installment was timely paid. [CC §2954.5] 

A payment received in the month following a delinquent and unpaid installment is deemed to be receipt of the most recent payment due on the loan, not payment of the most outstanding delinquent installment. Thus, for a series of payments which are always one month late, only one late charge is permitted by the lender over the entire period since only one installment has been missed. The charge is for the one missed installment which still remains unpaid by the homeowner. [CC §2954.4(b); B & P C §10242.5(b)] 

However, for accounting purposes, funds from the most recent payment are applied to the interest accrued for the month of the oldest delinquency. 

The statutory one-delinquency, one-charge rule does not apply to carryback sales even if it is negotiated by a broker. 

Final/balloon payments untimely paid 

When a final/balloon payment on a loan or an installment sale becomes delinquent, a private lender or carryback seller may enforce a default rate provision which increases the interest rate on the remaining principal, unless the debt is secured by an owner-occupied single family residence (SFR) or is a broker-arranged loan. [Southwest Concrete Products v. Gosh Construction Corporation (1990) 51 C3d 701] 

However, the default rate charge must be reasonable and triggered only by the expiration of any grace period for delivery of the final payment. [Garrett, supra] 

Impound accounts 

An impound account is a money reserve, also called an escrow account, consisting of a property owner’s funds advanced to a lender or carryback seller with the regularly scheduled payments. From the impounded funds, the lender or carryback seller pays specified obligations the owner periodically owes on the property, such as: 

  • property taxes; 
  • insurance premiums; 
  • assessments for common area or easement maintenance; 
  • water stock; or 
  • bonded off-site improvements. 

To fund the impound account, a pro rata amount of the costs anticipated to be incurred to pay annual taxes, assessments and insurance premiums (TI), is collected each month along with the monthly principal and interest (PI) payments (PITI). 

For late charge purposes, the tax and insurance portion – impounds – of the owner’s monthly PITI payment must not be included in the formula for computing the amount of the late charge. The TI funds are the owner’s money, accumulated by the carryback seller to pay obligations owed by the owner to others. 

Enforcement of the late charge 

Refusal or failure of an owner to meet a demand to pay a late charge agreed to in a trust deed note is a non-material breach of the note and trust deed. Thus, non-payment of a late charge by itself does not justify a call of the loan or initiation of foreclosure. [Baypoint Mortgage Corporation v. Crest Premium Real Estate Investments Retirement Trust (1985) 168 CA3d 818] 

No lender or carryback seller is entitled to foreclose on an owner who has tendered all installments which are due, but has failed to pay outstanding late charges. Collection of late charges when no other monetary breach exists must be enforced by means other than foreclosure. 

Additionally, a private lender making a loan on any type of real estate is required to furnish the owner with a semi—annual accounting for the total amount of late charges due and unpaid during the accounting period. [CC §2954.5(b)] 

For late charges on a carryback note secured by property improved with only a one-to-four unit family residence, the carryback seller must provide the owner with an annual accounting statement detailing any late charges due and unpaid during the entire year. [CC §2954.2(a)] 

Consider an owner of real estate who is delinquent on his January payment for a loan made by a private lender and secured by his property. A timely notice and demand is made by the private lender for payment of the late charge. Before the grace period for the February payment expires, the private lender receives an amount equal to one installment. 

Can the private lender reject the owner’s principal and interest (PI) payment since the payment did not include the late charge or the past payment? 

No! The private lender must accept the owner’s installment. Further, if the late charge is not paid, the lender must notify the owner every six months of the outstanding unpaid late charges if he is to eventually enforce collection of the unpaid late charges. [CC §2954.5(b)] 

A court action to collect the late charge is not advisable. An action would violate the one-action rule and cause a forfeiture of the trust deed lien since the late charge is part of the debt originating under the terms of the note and secured by the trust deed. [CCP §726(a)] 

Thus, the collection of accumulated unpaid late charges is limited to a demand for reinstatement to rescind a foreclosure (started due to a material breach) or on a final payoff, if a proper periodic accounting is made of the accumulated late charges. 

Late charges and public policy 

Carryback sellers and lenders holding notes secured by property other than owner-occupied single family residences (SFRs) tend to assume they can charge late fees of any amount since the statutory limitations only apply to loans on one-to-four unit SFRs, or loans made or arranged by a real estate broker on any type of property. This conclusion is generally called a negative presumption, and it is usually erroneous. 

However, legislation imposed on late charges for loans encumbering SFRs and one-to-four unit residential properties tends to establish public policy for amounts which are deemed reasonable. Further, case law has set standards requiring late charges to bear a reasonable relationship to the cost of the lender’s collection efforts and lost use of the delinquent payment. [Garrett, supra]