Many people believe that as long as 2 parties sign on a contract, then it must be legal and binding – aka, you must follow it.
That is not true, because contracts must still obey legislations, which are laws enacted by legislators. Specifically, you cannot put any clause you’d like onto a mortgage commitment or mortgage renewal agreement.
Under the Interest Act, lenders are not allowed to increase interest rates upon default by the borrower, even if the mortgage agreement allows for this. For borrowers, this law protects them from increased interest rates or penalties if they breach a term of the mortgage agreement. In situations where there is more than one registered lender on a property, the law protects the equity so subsequent lenders don’t suffer, which we will explain further below.
Under the Criminal Code of Canada, there are restrictions on how much interest can be charged on a loan, regardless of whether it is in default. Under the Code, a lender is not permitted to charge more than 60% Effective Annual Rate (EAR) per year, which equals 47% Annual Percentage Rate (APR). If a lender attempts to charge more than this, they could face severe penalties, including fines or even going to jail for as much as five years.
To prevent any loopholes, interest includes all fines, fees, commissions, expenses and penalties paid in connection with the loan.
Also, the law is expected to change soon to rely exclusively on APR and will reduce the permitted from 47% APR to 35%.
So, what does this mean for borrowers and lenders in a practical sense? To illustrate, we will consider the following scenarios using Jack and Susan. Jack is the borrower and Susan is the lender.
Scenario #1: Jack, as borrower and Susan, as lender, agree to a 8% interest rate that will apply throughout the whole term of the mortgage. The only penalties charged on default are damages actually incurred by Susan and there is no interest rate increase if Jack defaults.
Since the rate of interest is below the criminal rate listed above, lender Susan can rest easy knowing she cannot be criminally charged. However, if borrower Jack fails to make the required payments, Susan would only be able to charge the agreed upon 8% and can only charge penalties that are actually incurred.
Unfortunately, Susan suffers a lot of stress and anxiety not knowing when the mortgage would be paid back, but she cannot use penalties to compel the borrower to pay and she cannot be compensated for her stress or anxiety.
Scenario #2: Borrower Jack and lender Susan agree to a list of penalties that would apply if Jack doesn’t pay the loan back when due. These penalties include increased interest rates from 8% to 20%, as well as several service fees. In total, the increased interest and penalties result in an equivalent interest rate of 31%.
Fortunately, since the rate of interest is below the criminal rate, lender Susan does not need to worry about being criminally charged. However, she does face several other risks.
Firstly, the increased interest rate clause would be entirely invalid. This means the most Susan can charge in interest is the 8% agreed upon.
Additionally, if any of the fees Susan intends to charge are beyond the actual expenses incurred by Susan as a result of the default, these penalties would also be unenforceable.
Furthermore, under the Interest Act, if Jack paid these penalties or increased interest without knowing they were illegal, he could demand that the penalties and interest be paid back to him. Jack could even force Susan to pay him interest on the amount he overpaid by.
Scenario #3: Susan is really afraid Jack will try to default on the loan, so Jack and Susan agree to an interest rate of 65% per year, but there is no increased interest rate or penalties.
Since there are no fees or penalties for default and the interest rate doesn’t increase on default, this scenario doesn’t violate the Interest Act, but it sure does breach the Criminal Code.
In this case, a court could declare the whole agreement was illegal and unenforceable, or it could just remove the criminal interest rate and only allow the lender to charge the amount permitted under the Courts of Justice Act, which is currently around 5%, but was as low as .5% in 2022.
Additionally, Susan could face up to 5 years in prison, or a combination of fines and up to 2 years in prison.
Scenario #4: Jack and Susan agree to an interest rate of 8% for the first 11 months of a 12-month term with an increase to 20% during the final month.
This is arguably the best solution for everyone involved. Since the Interest Act’s prohibition is on charging increased amounts due to a default, this option could serve as an exception to the rule. Also, since the rate charged is no where close to the criminal rate, Susan is safe. However, while this strategy could serve as a good solution, lenders should be warned that the courts have not been consistent in how they interpret these clauses. While many cases have held these clauses do not violate the Interest Act, others have disagreed and this interpretation is subject to change by the Court.
Unfortunately, this would only provide the increase based on time and not on defaulting. As such, if Jack stopped making payments after 5 months, Susan would be prohibited from increasing the interest rate and would need to sue Jack using the 8% rate effective at the time of the default.
Scenario #5: Jack and Susan agree to a 20% interest rate, but also agree to a “Good Standing Discount” of 12%. Based on this, Jack will receive a discount of 12% as long as he is in good standing, but if in default, the interest would be the full amount of 20%.
Unfortunately, while this may sound like an excellent solution to the Interest Act, the Supreme Court of Canada has declared that this is not permitted and that the use of discounts “offends” the Interest Act. As such, Susan would be prohibited from applying the 20% rate and would only be entitled to the 8%, plus actual losses.
Scenario #6: Jack already has a first mortgage of a $1,000,000 that has penalty clauses and an increasing rate of interest on default. Based on equity of $200,000, Susan lends Jack an additional $100,000 as a second mortgage.
Unfortunately, after a few months, Jack defaults on the first mortgage. After 6 months of penalties and added interest have increased Jack’s debt on the first mortgage to the full value of the property, which leaves Susan with nothing to recover.
Thankfully for Susan, the penalties and added interest charged on the first mortgage would be found invalid.
So, Susan would still have access to the equity in the home after the first lender is paid out based on the non-defaulting terms to the mortgage.
The goal of the Interest Act is to protect vulnerable borrowers, as well as lenders in second priority, like Susan is in this situation.
Conclusion
It is extremely important that you speak to a knowledgeable lawyer before entering into a mortgage with any default clauses like the ones described above.
As you can see, some solutions listed above could be extremely helpful to protect the lender from losses, but it is essential that the mortgage agreement is properly drafted. For more detailed information on real estate secured lending, we recommend consulting the experts at Varity Law Professional Corporation. Here our team has a lot of experience representing both lenders and borrowers and can advise on all aspects of the lending process. To discuss your options as a lender or as a borrower, we invite you to book a free consultation here: https://calendly.com/sabrina-668/1stfreeconsult
Jonathan Thibert is one of the lawyers at Varity Law, where we specialize in Real Estate, Wills & Estate, and Business Law. This article is meant for general legal information only, for specific legal advice applicable to your situation, please book a 1st free consultation with us: https://calendly.com/sabrina-668/1stfreeconsult
