The default rate looks like a modest percentage. The base it applies to, the whole principal for every day of default, is what makes it expensive.
Default interest is usually the note rate plus a fixed margin, charged on the whole outstanding balance for every day an event of default continues, not just on the payment that was missed. On an illustrative $40,000,000 loan at 6.25 per cent with a 4.00 per cent default margin, actual/360, a 90-day payment default costs $400,000 of default interest plus $31,250 of late charges, on top of the $625,000 of interest missed. Charged only on the overdue amounts, the same default would cost $10,677.
Worked in full in How to Read a Real Estate Loan Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most borrowers know their loan has a default rate. Fewer have worked out what it does in money, because the clause reads as a percentage and the percentage looks modest. The base it applies to is what makes it expensive: the full principal, from the event of default until it is cured or waived, whichever kind of default it is.
| Term | Value |
|---|---|
| Outstanding principal | $40,000,000 |
| Note rate, fixed | 6.25% |
| Default margin over the note rate | 4.00% |
| Default rate | 10.25% |
| Day count | actual/360 |
| Late charge, % of each overdue payment | 5% |
| Monthly interest payment (30 days) | $208,333 |
| Length of the default | 90 days |
Default interest = principal × default margin × days in default ÷ 360
= 40,000,000 × 4.00% × 90 ÷ 360 = 400,000
Late charges = 5% × 208,333 × 3 = 31,250
In Excel: =Principal*Margin*Days/360. If the agreement states the default rate rather than the margin, charge (default rate − note rate), because the note rate is already in the regular interest.
The default margin runs on the whole $40,000,000 at $4,444 a day. Over 90 days that is $400,000. Each of the three missed payments of $208,333 also attracts a one-off late charge of 5 per cent, $31,250 in total. To reinstate the loan, the borrower pays the missed interest, the default interest and the late charges.
| Item | Amount |
|---|---|
| Missed interest, three payments | 625,000 |
| Default interest on the full balance | 400,000 |
| Late charges | 31,250 |
| Total to reinstate | 1,056,250 |
The penalty part, $431,250, is 69 per cent of the payments that were missed and 108 basis points of the loan. Expressed as a rate it is simply the 4.00 per cent margin for the time in default: whatever the cause, the borrower pays an extra 4.00 per cent a year on everything it owes.
The base is the clause to read. Some agreements apply the default rate only to sums overdue. On that wording, the three missed payments carry 10.25 per cent for 90, 60 and 30 days respectively, which comes to $10,677. Full-balance wording costs 37.5 times as much for the same default. Lenders draft for the full balance on the reasoning that a loan in default is a riskier loan as a whole, not just a late payment, and that the margin compensates for that risk and the cost of managing it.
Whether a given default rate can be enforced, and on what base, depends on the governing law and on the facts. Courts in many jurisdictions test default interest against rules on penalties, usury or unfair terms, and a modest margin that reflects the lender's higher risk is generally easier to defend than a punitive one. The arithmetic here is general and illustrative; it is not legal advice on any particular agreement.
Default interest is not reserved for missed payments. A covenant breach, an unpermitted transfer or a failure to deliver financial statements can each be an event of default once any cure period expires, and the default margin then runs on the full balance with no payment missed at all: $400,000 for 90 days here. The cure periods and what counts as an event of default matter as much as the rate. How a covenant breach is cured, and what it costs, is worked in the cure ratio in a coverage covenant.
| Margin | 30 days | 90 days | 180 days | 365 days |
|---|---|---|---|---|
| 2% | 66,667 | 200,000 | 400,000 | 811,111 |
| 4% | 133,333 | 400,000 | 800,000 | 1,622,222 |
| 5% | 166,667 | 500,000 | 1,000,000 | 2,027,778 |
The cost is linear in both margin and time, so the duration is the variable a borrower controls. A default at maturity is the expensive case: if the balloon is not repaid and the borrower spends 180 days negotiating an extension, default interest adds $800,000 and total interest at 10.25 per cent comes to $2,050,000 for the half-year. Actual/360 adds a little more over a full year: 365 days of the margin cost $1,622,222 against $1,600,000 on 30/360, the effect set out in actual/360 versus 30/360.
The common mistake is to model default interest on the missed payment, or to ignore it because the lender may waive it. Waiver is a negotiation, and the lender negotiates from the accrued figure. In a workout, accrued default interest is often the first thing a lender gives up in exchange for a paydown or tighter terms, which makes it a currency with a known value. A borrower that has not computed it does not know what it is being offered.
The second mistake is to read the default rate as a cap on the cost. Late charges, enforcement costs and, on fixed-rate loans, prepayment premiums on any acceleration sit on top of it.
A practical check for any borrower in difficulty: accrued default interest grows by $4,444 a day on this loan, whether or not anyone is talking. Every week spent before opening a standstill or a waiver discussion adds roughly $31,000 to the figure the lender starts from.
Default interest = principal × margin × days ÷ 360, on the full balance unless the clause says otherwise. Here 90 days cost $400,000 plus $31,250 of late charges, 37.5 times the overdue-only reading. Read three things: the base, the margin, and when an event of default starts. The book reads the default and remedies provisions clause by clause; the free workbook for this case includes a one-page model of your own loan.
It depends on the wording, and most commercial real estate loans use the whole outstanding balance. On a $40,000,000 loan with a 4.00 per cent default margin, 90 days cost $400,000 on the full balance. Charged only on three overdue monthly payments of $208,333, the same default would cost $10,677, 37.5 times less.
Agreements usually set it as the note rate plus a fixed margin, and margins of a few percentage points are common in practice. Each point matters in proportion to the balance and the time: on $40,000,000 for 180 days, a 2 per cent margin costs $400,000 and a 5 per cent margin $1,000,000.
Yes, if the agreement triggers it on any event of default. A financial covenant breach or a missed reporting deadline, once its cure period expires, can start the default margin on the full balance with every payment made. On the example loan that is $4,444 a day, $400,000 for 90 days.
This article is one calculation from How to Read a Real Estate Loan Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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