Quick overview

Default interest is the higher interest rate or surcharge a lender applies after a borrower breaks the loan’s payment terms. Lenders use it to compensate for added credit risk, administrative costs, and the time value of money lost while a debt goes unpaid. It is usually written into the loan contract as a specific default-rate clause or referenced as an increase in the borrower’s APR.

How lenders typically calculate default interest

Most consumer and commercial loan contracts express default interest in one of these ways:

  • As a fixed additional percentage above the contract rate (for example, contract rate + 3 percentage points).
  • As a specific default annual rate (for example, 18% when the borrower is in default).
  • As an automatic increase to a penalty APR (common with credit cards).

Common calculation method (daily simple interest):

Code-style formula:

Default Interest = Principal × (Default Annual Rate / 365) × Days in Default

Example: A $10,000 loan with a contractual default rate of 10% that is unpaid for 30 days.

Default Interest = $10,000 × (0.10 / 365) × 30 ≈ $82.19

Notes about the example:

  • This uses a 365-day year. Some contracts use a 360-day convention—check your agreement.
  • For credit cards or other products that compound interest, interest-on-interest can make the effective balance grow faster.

Why calculation details matter

Small differences in the calculation method change the cost materially over time:

  • Day-count convention: 365 vs 360 days affects daily rate and total interest.
  • Compounding: Some lenders may capitalize interest (add unpaid interest to principal), which increases future interest charges.
  • Fees and collection costs: Default clauses often permit recovery of late fees, attorney fees, and collection costs in addition to default interest.
  • Payment application rules: Contracts may require payments to be applied first to fees, then interest, then principal—making it harder to reduce principal while in default.

Always read the specific loan agreement to confirm which conventions apply.

Real-world examples and variations

  • Credit cards: Many card agreements move your APR to a penalty or default APR after one or more missed payments. That default APR is typically much higher and is applied to the outstanding balance and new purchases according to the card’s terms.

  • Mortgages: A missed mortgage payment can trigger late fees and, if prolonged, acceleration (the entire loan balance becomes due). Some mortgage contracts include a default rate that applies after acceleration or in the event of foreclosure. Mortgage servicers also add fees for servicing and legal costs.

  • Commercial loans: Business loan agreements often have explicit default-rate clauses, cross-default provisions, and remedies that include immediate acceleration, higher default rates, and indemnity for recovery costs. See our glossary entry on Default Events Explained for more on remedies and cure options: Default Events Explained: Remedies, Notice Periods, and Cure Options.

  • Tax and government debts: The IRS and many states apply statutory interest to unpaid taxes; interest and penalties are separate charges. For the IRS, current interest and penalty rules are posted at IRS.gov and change periodically—refer to the IRS for the current rates (see How the IRS Applies Interest vs Penalties on Late Tax Payments): IRS – Interest vs Penalties.

Legal limits and protections

Default interest is governed by the loan contract and by state and federal law. Important points:

  • Usury laws: States set usury limits (maximum allowable interest rates) that can cap how high default interest may be. These laws are complex and vary by state, so compliance depends on the borrower’s state, the lender’s charter (state bank vs national bank), and other factors. If you suspect an illegal rate, consult a consumer attorney or your state regulator.

  • Consumer protections: The Consumer Financial Protection Bureau (CFPB) enforces federal consumer-finance rules, and it investigates abusive practices related to default interest and collections. For general guidance on consumer rights and debt collection practices, see the CFPB: https://www.consumerfinance.gov.

  • Contract terms control where lawful: When a court enforces a loan contract, it typically enforces the default-rate clause unless it is illegal or unconscionable under applicable law.

How default interest affects your balance and payments

Default interest increases the amount you owe and can change how every payment is allocated:

  • Higher interest portion: More of each payment goes to interest and fees, slowing principal reduction.
  • Potential capitalization: Unpaid interest sometimes gets added to principal (capitalized), which then accrues interest itself.
  • Acceleration risk: In many contracts, continued default lets lenders accelerate the loan — making the full principal due immediately — which can trigger rapid collections or foreclosure.

Example of payment allocation impact:
A borrower with a $5,000 balance who moves from 8% to 18% APR will see a larger monthly interest charge. If they make the same monthly payment as before, less principal is repaid and the loan takes longer to clear.

Practical steps to limit or reverse default interest

If you face default interest or are at risk of default, take these steps promptly:

  1. Read your loan agreement to identify the default-interest clause and notice/cure periods.
  2. Contact the lender immediately. Lenders often prefer a negotiated cure (forbearance, repayment plan, or loan modification) to avoid costly collections.
  3. Request a payment plan, temporary relief, or modification in writing. Get all agreements in writing.
  4. Consider consolidation or refinancing if creditworthy — moving the balance to a lower-rate product can stop default interest from growing.
  5. Use hardship programs: For mortgages, student loans, or certain consumer loans, servicers often have hardship options. Check the lender’s hardship policy.
  6. Document communications and keep copies of any letters, offers, or agreements.

If you suspect unlawful practices or feel pressured by debt collectors, contact the CFPB or your state attorney general.

Negotiation and legal options

  • Ask for a reinstatement or modification that returns the loan to its pre-default rate once you cure the delinquency.
  • Negotiate a payoff or settlement to avoid prolonged legal costs and reduce the total balance.
  • If a lender charged usurious or unlawful default interest, consult a consumer attorney — you may have defenses or counterclaims.

For business and commercial borrowers, hiring counsel early is often essential because default clauses can trigger cross-defaults and other remedies across multiple agreements. See our related post on how lenders assess default risk for context on underwriting and remedies: How Lenders Assess Loan Default Risk: A Plain-English Guide.

Common misconceptions

  • Myth: Default interest is always a fixed multiple of the original rate. Fact: It depends on contract language; sometimes it’s a fixed rate, sometimes an extra spread, and sometimes a flat penalty APR.
  • Myth: Default interest stops once you make a payment. Fact: Unless the lender agrees to reinstate the original terms, default interest may continue until cure or refinance.
  • Myth: Only large defaults trigger default interest. Fact: Even a single missed payment can trigger a penalty APR on some credit products.

Checklist: What to look for in your loan documents

  • Exact default rate and how it is expressed (percentage or spread).
  • Whether the rate is annual and whether it is compounded.
  • Day-count convention (360 vs 365 days).
  • Fee and collection-cost provisions.
  • Cure periods, notice requirements, and acceleration clauses.

Authoritative resources (useful starting points)

Internal resources on FinHelp

  • Default Rate (explains the contractual clause and how default rates are written): Default Rate
  • Default Events Explained: Remedies, Notice Periods, and Cure Options (how defaults are triggered and what lenders can do): Default Events Explained
  • How Lenders Assess Loan Default Risk: A Plain-English Guide (context on underwriting and why default penalties exist): How Lenders Assess Loan Default Risk

Final takeaways

Default interest can markedly increase the cost of borrowing and slow progress toward paying down a loan. The exact calculation depends on your loan agreement and applicable law. If you’re near default or already there, act quickly: read your contract, communicate with your lender, and explore repayment, modification, or refinance options.

Professional disclaimer: This article is educational and does not constitute legal or financial advice. For advice tailored to your situation, consult a qualified attorney or licensed financial professional.