Can we add a provision to our consumer residential loan agreements imposing a default interest rate? Currently, only our HELOC loan agreements provide for default interest rates, which are triggered when the loan is being terminated or accelerated. If a HELOC borrower becomes delinquent or pays late, can we impose the default interest rate, even if the loan is not being terminated or accelerated?

Yes, we believe you may add a default interest rate provision to your consumer residential loan agreements, but they may be subject to court scrutiny if they are not considered “reasonable.”

Illinois courts have examined loan agreements with default interest rates and generally have found that “reasonable” rate increases after default are permissible. For example, in 2010, an appellate court found that a default rate increase of 5% (from 2.25% to 7.25% over the loan’s index rate) was permissible in the context of a business-purpose mortgage loan. The court noted that default rate increases must be “reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss.” That court also noted that Illinois courts have upheld other, larger default rate increases in the past, including one in the context of a residential mortgage loan.

However, federal law may limit your ability to enforce default rates in certain situations. For example, Regulation Z prohibits an increased interest rate after default for HOEPA (high-cost) loans. Also, if your institution obtains a court judgment against a borrower, both Illinois and federal rules of civil procedure limit the interest that can be charged post-judgment. If a borrower files for bankruptcy, the bankruptcy court also may scrutinize the interest rates you are charging to determine whether your default interest rate is “reasonable.”

As to your second question, based on the facts presented, we do not believe that you may impose the default interest rate for a HELOC unless the note has been terminated or accelerated. If the only triggers for the default interest rate set forth in the loan agreement are for termination or acceleration of the note, and neither of those triggers has occurred (and a delinquency or late payment does not cause termination or acceleration to occur), we do not recommend imposing the default interest rate.

For resources related to our guidance, please see:

Inland Bank and Trust v. Knight, 399 Ill.App.3d 378, 383 (1st Dist. 2010) (A default interest rate increase “will be enforced if the damages are ‘reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. . . .’”)

Inland Bank and Trust v. Knight, 399 Ill.App.3d 378, 384 (1st Dist. 2010) (“Illinois has upheld liquidated damages clauses over a fairly wide range of values. From the previously cited cases, the supreme court in Baker upheld an increase from 6% to 7%. In Bane, the court upheld a provision in a promissory note which required the debtor to pay interest at the rate of 30% per annum after maturity. The supreme court in Walker v. Abt, 83 Ill. 226 (1876), upheld a provision in a note increasing the interest rate from 10% per annum to 20% per annum upon maturity of the note. While the relatively ancient cases of Bane and Walker predate usury laws, they nevertheless provide support for our holding that provisions for higher interest in the Note are valid and enforceable.”)

Baker v. Loves Park Sav. and Loan Ass’n, 51 Ill.2d 119, 127 (1975) (“The charge of the additional 1 percent interest is not unreasonable and in this case does not constitute unconscionable or inequitable conduct on the part of the lender.”)

Walker v. Abt, 83 Ill. 226, 232 (1876) (“The allowance of twenty per cent as liquidated damages, after the maturity of the Walker note, is sanctioned by Lawrence v. Cowles, 13 Ill. 577; Blair v. Chamblin, 39 ib. 529; Bane v. Gridley, 67 ib. 388; Witherow v. Briggs, 67 ib. 96; Downey, Admr. v. Beach, 78 ib. 53.”)

In re Kimbrell Realty/Jeth Court, LLC, 483 B.R. 679, 690 (Bankr. Ct. C.D. Ill., 2012) (Holding that a default interest rate increase of 4% was reasonable and stating generally that “in Illinois, there is no statutory ceiling on the rate of interest that may be charged on mortgage loans. U.S. Bank Nat. Ass’n v. Clark, 216 Ill.2d 334, 347, 297 Ill.Dec. 294, 837 N.E.2d 74 (2005). Neither is there a general prohibition against default interest. A borrower may agree to pay a higher rate of interest after default and the additional amount will be treated as liquidated damages, not as a penalty. Baker v. Loves Park Sav. & Loan Ass’n, 61 Ill.2d 119, 127–28, 333 N.E.2d 1 (1975).”)

Regulation Z, 12 CFR 1026.32(d)(4) (“A high-cost mortgage shall not include the following terms: . . . (4) An increase in the interest rate after default.”)

Illinois Code of Civil Procedure, 735 ILCS 5/2-1303 (“Judgments recovered in any court shall draw interest at the rate of 9% per annum from the date of the judgment until satisfied . . . .”)

Federal Code of Civil Procedure, 28 USC 1961 (“Interest shall be allowed on any money judgment in a civil case recovered in a district court. . . . Such interest shall be calculated from the date of the entry of the judgment, at a rate equal to the weekly average 1-year constant maturity Treasury yield . . . .”)

U.S. Bankruptcy Code, 11 USC 506(b) (“To the extent that an allowed secured claim is secured by property the value of which, after any recovery under subsection (c) of this section, is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.”)