Common terms in consensual payment obligations
Written documents reflecting consensual payment obligations obviously include a term calling for payment of the principal amount of the obligation. In addition, such written documents, particularly those prepared by institutional lenders or by merchants selling on credit, typically include some or all of the other terms described below. Some of these terms will also appear in the security instruments (e.g. deed of trust, mortgage, or security agreement) by virtue of which the underlying obligation is secured.
For loans or credit sales secured by real property, the lender or credit seller will typically require a form of written contract known as a promissory note and most of these terms will be found in the note. Consult our sample promissory note to see if you can find any of the terms I describe here. In commercial or consumer loans secured by personal property, the lender will also often require the debtor to sign a promissory note. In some consumer credit sales secured by personal property, the terms may be reflected in a retail installment contract rather than a promissory note, often because state law may prohibit the use of a promissory note in such a transaction for reasons we explore in Commentary.Assetion of claims and defenses against assignees.
Interest
"[C]ompensation [to a creditor] allowed by law or fixed by
the parties for the use, or forbearance, or detention of money." Cal. Civ. Code
1915. The term is a familiar to anyone who has taken out a student or an automobile
loan or who has used a credit card.
Many borrowers, especially consumer borrowers, are unaware of the large amounts of money payable as interest, particularly in connection with large, long term obligations. Accordingly, in addition to federal and state usury law that establish maximum amounts of interest that some lenders may charge, the federal Truth in Lending Law and its implementing regulations require extensive disclosure to consumer debtors in advance of consummation of a wide variety of loans and credit sales. The Truth-in-Lending Law subsumes the definition of interest within a broader concept known as "Finance Charge." Regulation Z, 12 C.F.R. 226.4. A Finance Charge is the cost of consumer credit as a expressed as a dollar amount and may include a variety of charges in addition to interest (such as points, appraisal fees, and credit or property insurance premiums) that are imposed by a creditor as an incident to or condition of the extension of credit.
Exploration of
usury law and truth in lending disclosure is beyond the scope of these materials.
Nonetheless, we think it useful to illustrate the large amounts of interest that may be
payable on large, long term obligations. Consider a $100,000 loan to finance purchase of a
residence, repayable over 30 years, with interest at 7.5% per annum, payable monthly. From
payment tables readily obtainable from lenders, publishers of financial tables, book
stores or stationery stores, or from the
internet, we learn that the borrower must pay $699.22/month for
360 months. During the first month of the loan, interest of $625.00 accumulates
($100,000 x .075÷12) and therefore $625.00 of the first monthly payment is allocated to
the payment of interest and only $74.22 is allocated to the payment of principal. The
principal is thereby reduced to $99,925.78 following receipt of the first monthly payment.
During the second month of the loan, interest of $624.53 accumulates ($99,925.78 x
.075÷12) and only $74.69 of the second monthly payment reduces principal. You can see by
repeating the calculations for a few more months that the borrower pays a lot of interest
and not much principal during the early years of a loan. During the first year of the
loan, for example, the borrower will have paid $7,468.67 in interest, $921.97 in
principal, and the principal will have been reduced to $99,078.03 at the end of the first
year. After many years, as the principal to which the interest rate is applied declines,
interest allocations decrease and principal reductions accelerate.
Consider a $5,000,000 commercial loan to finance the acquisition
of a hotel, repayable over 20 years, with interest at 7.5% per annum, payable monthly.
Monthly payments will be $40,280. During the first month of the loan, interest of $31,350
accumulates and, therefore, $9,030 of the first monthly payment will be applied to
principal. After one year, the borrower will have paid slightly less than $375,000 in
interest and slightly more than $108,000 in principal. At the beginning of the second
year, the outstanding balance will be in the neighborhood $4,890,000.
In both of these examples, the debt is fully
amortized, that is, the entire principal amount of the debt is repayable over the period
of the loan. In some transactions, the parties agree that the debt will not be fully
amortized. A debt may be payable interest only (i.e. without any amortization) for a
period of years with payment in full of the outstanding principal balance at the end of
the loan term. For example, in our $100,000 loan to finance acquisition of a residence,
the parties might agree that the borrower will pay interest only ($625/month) for five
years (a total of $37,500) with the principal ($100,000) being due at the end of five
years. Any payment of principal, payable at the end of a period of a loan, which exceeds
the normal amount of monthly payments during the term of the loan is referred to as a
balloon payment. Debts may also be partially amortized (some repayment of principal during
the term of the loan with a balloon payment at the end of the term) or even negatively
amortized (monthly payments of less than interest with a balloon payment at the end of the
term that exceeds the amount of the initial principal by the amount of unpaid accumulated
interest). Some lenders also offer reverse annuity mortgages, often to senior
citizens with limited income but substantial equity in residential real property. In
such transactions, the lender makes agreed monthly payments to the borrower and the debt
thus generated is secured by the borrower's real property. Repayment will be from
the proceeds of the sale of the borrower's real property, such as a sale by the estate of
the owner following the owner's death.
The preceding examples have assumed fixed interest rates.
Under the terms of a promissory note, interest may fluctuate. For example, a
lender may offer an adjustable rate loan, often referred to as Adjustable Rate Mortgage
("ARM"), in which the interest rate is tied to fluctuations in stated market
rates of interest. Or, a developer (particularly of new homes) may offer an
"interest-rate buydown" as an incentive to purchase, paying the financing lender
to reduce for a stated period the interest rate charged to the purchaser/borrower.
Acceleration
clause
An acceleration clause provides that a debt payable in
installments will be due in full upon default by the borrower in the event the lender
elects to accelerate the debt. Here is an example of an acceleration clause drawn from our
sample security agreement:
Upon the occurrence of an Event of Default, or if Secured Party deems payment of Debtor's Obligations to Secured Party to be insecure, and at any time thereafter, Secured Party, may, at its option, without demand, notice of intention to accelerate, notice of acceleration, notice of nonpayment, presentment, protest, notice of dishonor, or any other notice whatsoever, to the Debtor, declare all Obligations secured hereby immediately due and payable . . .
The most common default that triggers acceleration is failure
to pay an installment when due. But promissory notes and security instruments usually
define other events of default. Thus, for example, the debtor's failure to pay property
taxes or insurance premiums or the debtor's commission of waste on the property may permit
the lender to elect to accelerate the debt.
The need for an acceleration clause derives from a peculiar
common law contract rule relating to anticipatory repudiation of a contract. At common
law, a party repudiating its obligations under a contract can generally be sued for
damages by the aggrieved party prior to the time performance under the contract by the
repudiating party is due (i.e. prior to breach). The classic case on this point is Hochster
v. De La Tour, 118 Eng. Rep. 922 (Queen's Bench 1853). However, in most jurisdictions
this right to sue prior to breach is unavailable to the aggrieved party if it has already
fully performed its obligations under the contract. Where property or services have been
sold on credit, or where a loan has been extended, the seller or the lender generally has
no future performance obligation because property sold has already been delivered or loan
funds have already been advanced. Thus, where a buyer or borrower fails to pay an
installment when due, the seller or lender, in the absence of an acceleration clause, may
only sue for the unpaid installment because breach as to future installments has not yet
occurred. "Once the promissee has done all there is for him to do under the contract
and the promissor's obligation is confined to payment by installments as specified by the
contract, the doctrine of anticipatory breach has no field of operation and will not
intercede to rescue the promissee from the consequences of the absence of an acceleration
clause." Rosenfeld v. City Paper Co., 527 So.2d 704 (Supreme Court of Alabama 1988).
An acceleration clause, as part of the agreement between the parties, gives the creditor
an election to treat the entire sum due at the time of any default so that the aggrieved
party need not wait to sue for future installments.
The effect of an acceleration clause may be undone by a statute
that allows the debtor to reinstate the original payment terms of the obligation by curing
only the default or defaults that triggered the acceleration. See Commentary.Reinstatement.
Conversely, in the real property context, a statute may permit acceleration in the absence
of an acceleration clause where the real property that stands as security for the debt
cannot without injury to the parties be sold in portions small enough to satisfy the
portion of the debt as to which there has been a default. See, e.g., Cal. Code Civ. Proc. 728.
Due on sale clause
A due-on-sale clause is a species of acceleration clause under
which the entire outstanding debt becomes immediately due and payable upon sale or
transfer of any interest in the property that secures the debt. Such a clause is
frequently used in deeds of trusts or mortgages.
A due-on-sale clause protects a lender against assumption of a
seller's liability on an outstanding note by a buyer of the property with whom the lender
has not dealt and about whose credit the lender knows nothing. Once exercised and the debt
paid, the effect is to free the lender from a loan that may be
below market rates of interest by virtue of changes in economic conditions since the time
the loan was made. In California, such clauses were successfully attacked in litigation as
imposing undue restraints on alienation. Wellenkamp v. Bank of America, 21 C.3d 943
(1978). Even though Wellenkamp was not widely followed in other jurisdictions, the concern
among institutional lenders prompted their development of adjustable
rate mortgages. In 1982, the controversy over due-on-sale clauses was put to rest by
federal legislation, the Garn-St.Germaine Act, which restored to lenders the right to
enforce due-on-sale clauses and pre-empted any state law to the contrary.
A prospective purchaser of real property may wish to purchase
real property by assuming an existing obligation secured by the real property, paying the
seller only the difference between the negotiated value of the property and the amount of
the debt secured by the mortgage and thereafter making the installment payments called for
in the assumed mortgage. Because due-on-sale clauses are generally included in the deed of
trust or mortgage, as well as in the promissory note, and because the deed of trust or
mortgage is recorded, such a prospective purchaser is put on constructive notice that the
loan can be called if the lender discovers and is unwilling to abide the purchaser's
assumption of the mortgage obligation.
The purchaser who agrees to assume a mortgage but who discovers a
due-on-sale clause prior to the close of escrow has the following options: (a) it may
contact the existing lender to negotiate a waiver of the due-on-sale clause; (b) it may
renegotiate the deal with the seller to condition the purchase on the purchaser's ability
to secure suitable financing to pay the additional amount now due and payable; (c) it may
claim that its duty to buy the property is now excused on the grounds that the purchase
agreement, either expressly or implicitly, conditioned the obligation to purchase on the
ability of the buyer to assume the existing mortgage.
Prepayment and
prepayment penalties
Due dates for payment of principal and interest stated in a
promissory note are terms of a contract between the parties. Clearly, late payment
is a breach of the contract, typically referred to as a default. While a lender does
not wish to be paid late, it may be less obvious, and perhaps counter-intuitive, that a
lender may not wish to be paid prior to due dates stated in the note
("prepayment"). Payment of an installment or payment of the balance of a
note prior to a due date (i.e. prepayment) will save the debtor interest and cost the
lender (or other holder of the note to whom the note has been negotiated) a corresponding
amount of income. In many instances prepayment will also trigger adverse tax
consequences for the holder of the note (such as earlier than anticipated recognition of
capital gain on the sale of real property). Accordingly, absent legislation to the
contrary, the proper interpretation of a note that does not mention prepayment is that the
borrower is not entitled to pay early and the lender is not obligated to accept early
payment. Such a note calls for payment at a specified time, neither later nor
earlier.
Of course the parties may agree to prepayment in the note. Consult our sample promissory note for an example. Lenders agreeing to accept prepayment will often insist upon a term in the note assessing an additional charge in the event of prepayment. This charge is often referred to as a prepayment penalty, but some lenders may use the phrase "prepayment privilege" to reflect their view that prepayment coupled with the prepayment charge should be construed as an alternative method of performing the contract that has been agreed upon by the parties. On occasion, however, the charge for prepayment will be construed as a liquidated damages clause and will be subject to general common law and statutory provisions governing the enforceability of liquidated damages clauses. See Ridgley v. Topa Thrift and Loan Association.
Note that statutes regulating prepayment and prepayment charges are not uncommon. Consider Cal. Civ.Code 2954.9, Cal. Civ. Code 2954.10, and Cal. Bus. & Prof. Code 10242.6.
Late charges
A debtor may be required to pay a late charge if the debtor fails
to make an installment payment when due or within a stated "grace period"
following the due date of an installment. California has regulated the imposition of late
charges on notes secured by single-family owner-occupied dwellings. See Cal Civil Code Section 2954.4. A late
charge is a liquidated damages provision of a contract and, as such, is subject to general
common law and statutory provisions governing the enforceability of liquidated damages
clauses. See Ridgley v. Topa Thrift and
Loan Association.
Attorney's fees
Under the "American rule", a successful litigant is not
entitled to reimbursement from an unsuccessful litigant for attorney's fees incurred by
the successful litigant unless a statute or agreement of the parties provides the
contrary. Accordingly, a consensual creditor often includes in the debt instrument a term
entitling it to recover reasonable attorney's fees incurred in the collection of the debt.
Such a term is also typically included in the security instrument for the purpose of
assuring the lender the right to recover attorney's fees expended in the protection or
foreclosure of the collateral.
The amount of attorney's fees that can be recovered may be
regulated by statute. For example, California limits the amount of attorney's fees which
can be recovered in connection with a non-judicial foreclosure of real property. The
statutory amount is conclusively presumed to be reasonable. See Cal. Civil Code Section 2924c(d) and 2924d. Additional fees are recoverable but are
not entitled to the conclusive presumption.
Balloon payment
A balloon payment is a lump sum payment of a substantial part or
all of the remaining balance due on a debt after the expiration of a stated period. For
example, if a note is payable interest only for a period of one year, with the entire
principal due at the end of that year, the payment at the end would be a balloon payment.
To protect forgetful or ill informed owner-occupants of one-to-four unit residences,
California legislation requires advance notification regarding balloon payments. See Cal. Civ. Code 2924i.
Dragnet clause
Under a dragnet clause, collateral is said to stand as security
for future debt of the debtor to the creditor (whether arising from contract, tort, or
otherwise), i.e. in addition to the debt that is the subject of the transaction for which
the security instrument is presently being executed. In some circumstances a court may
refuse to enforce a dragnet clause. See Commentary.Future Advances.1.