When a borrower pays late

Before doing anything, read the note. A properly drafted note answers most of the questions a late payment raises, and it limits what the lender may do as much as it empowers the lender.

• The due date. The schedule fixes when each payment is due. A payment is not late until that date has passed.
• The grace period. Most notes allow 10 to 15 days after the due date before a payment is treated as late. See grace period. Within it, nothing happens except that interest keeps running.
• The late fee. If the note sets a late fee, it can be charged once the grace period ends. If the note is silent, there is no fee. A fee has to be reasonable and stated in writing to be enforceable.
• Default. The note defines default: typically a payment unpaid for a set number of days, often 30, sometimes after written notice and a chance to cure.
• Acceleration. An acceleration clause lets the lender declare the entire balance due after a default. Without one, the lender can only demand the payments that have fallen due.

If the note lacks these terms, the lender’s position is weaker and the steps below still apply, but with less leverage. That is an argument for getting the note right at the start, which our guide to promissory notes covers.

Most late payments are forgetfulness, a bank delay, or a short cash squeeze. Treat the first one that way.

1. Confirm it is actually missed. Check the account the payment should have reached, and the date. A transfer sent on the due date may not post until the next business day.
2. Send a plain message. One or two sentences: the payment of $1,250 due on the 15th has not arrived, could you let me know when to expect it. No tone, no reminder of the relationship. The record should look businesslike if anyone reads it later.
3. Record it. Note the date the payment was due, the date you wrote, and what the borrower said. If a late fee applies after the grace period, record that too.

In a shared ledger, both parties can see that the installment is overdue and by how many days. That removes the need for the lender to be the one who keeps saying so.

A missed payment does not pause the loan. Interest accrues on the outstanding principal every day whether or not a payment arrives. On a $50,000 balance at 6 percent, that is about $8.22 a day, or roughly $250 over a month. When the borrower catches up, the catch-up payment covers any fee first, then the interest that has accrued, and only then principal. The schedule that follows is recomputed from the new balance.

This is worth explaining to the borrower in plain terms. A borrower who thinks a skipped payment simply moves the loan back one month will be surprised that the balance did not fall. A lender who waives the accrued interest is making a gift and should say so in writing, so the ledger and the tax position stay clear.

If the payment does not arrive after the first message, the lender has a sequence of choices. Each one is more formal than the last, and each should be exhausted, or at least considered, before moving to the next.

1. Wait. If the borrower has explained the delay and named a date, hold them to that date and do nothing else. Interest and any late fee continue under the note.
2. Accept a partial payment. Something is better than nothing, but say in writing that the partial payment is accepted on account and does not change the terms. Otherwise a pattern of accepting less can be read as agreement to less.
3. Change the schedule in writing. If the borrower’s circumstances have changed for more than a month, a modification may be the right answer: a longer term, a lower payment for a period, or interest-only for six months. Put it in an amendment to the note, signed by both parties, that states the new schedule and that all other terms remain. A verbal agreement to change a written note is hard to prove and easy to dispute.
4. Forbearance. A written agreement that the lender will not enforce the note for a stated period, in exchange for something: a resumed payment date, a partial payment, or additional security. It preserves the lender’s rights while giving the borrower room.
5. Forgive part of the debt. A lender who decides to write off some of the balance is making a gift of that amount. Gifts above the annual exclusion have to be reported, and forgiven debt can be income to the borrower in some situations. Talk to a tax adviser first, and document the forgiveness in writing with the amount and date.
6. Send a demand letter. A formal letter stating the amount overdue, the accrued interest and fees, the date by which payment is required, and what the lender will do if it is not paid. Send it in a way that produces a delivery record. This is usually the step that gets a response, and it is a prerequisite to the next one.
7. Sue on the note. Small claims court handles amounts up to a state-specific limit, often between $5,000 and $15,000, without a lawyer. Larger amounts go to the civil court, where a lawyer is advisable. The lender sues for the balance due under the note, plus interest, fees and sometimes costs if the note provides for them. A judgment can then be enforced against wages or bank accounts under state procedure.
8. Enforce the security. If the note is secured by property, the lender can proceed against the collateral after default, following the procedure that applies to that kind of security. Real property means foreclosure under state law. Personal property under a security agreement follows the Uniform Commercial Code. Neither allows self-help against a person or a home.

The statute of limitations on a written contract varies by state, commonly between three and ten years from the breach. A lender who waits too long loses the right to sue, so the decision to escalate should not be put off indefinitely.

A private lender is not exempt from the rules that govern collection, and a few things are off limits whatever the note says.

• Do not threaten anything the note and the law do not allow, including arrest, violence, or public exposure.
• Do not contact the borrower’s employer, relatives or friends about the debt, except a co-signer or guarantor who is a party to it.
• Do not call repeatedly, at unreasonable hours, or after the borrower has asked in writing for contact only by mail or email.
• Do not take or hold the borrower’s property unless the note gives a security interest in it and the law allows the method.
• Do not change the terms, the rate or the balance unilaterally. The ledger should show only what the note and any signed amendment permit.

Federal fair debt collection rules apply mainly to third-party collectors, but many states extend similar rules to original lenders, and harassment is actionable regardless. A lender who keeps to written, polite, infrequent communication and the steps above is on safe ground.

Some loans will not be repaid. A borrower who has lost a job, filed for bankruptcy, moved without a forwarding address, or simply stopped answering may be beyond reasonable collection. At that point the lender decides whether to keep the claim open or write the loan off.

A loan that was not made in the lender’s trade or business may qualify as a nonbusiness bad debt, which is deductible as a short-term capital loss in the year it becomes wholly worthless. The lender has to be able to show three things.

• A bona fide debt. A signed note with a rate, a schedule and a maturity date, and a record that both parties treated it as a loan. A transfer with no paperwork looks like a gift.
• Efforts to collect. The messages, the demand letter, and any legal steps, with dates. A lender who never asked for the money cannot show it became uncollectible.
• Worthlessness. Evidence that the debt has no remaining value: the borrower’s bankruptcy, insolvency, or disappearance, or a judgment that cannot be satisfied.

The ledger and the correspondence are the evidence. A loan serviced in NoteHouse carries its signed note, its payment history and its event record together, which is the file an accountant will ask for; see what protects the record. Because the rules are specific and the deduction is often examined, a tax adviser should confirm the position before the return is filed.