Key Takeaways:
- The legal rate of interest is the maximum interest rate lenders can charge on any debt.
- Interest rates exceeding this legal limit are considered usury, punishable in most states.
- Each U.S. state sets its own legal rate of interest and usury laws.
- Lenders may bypass these laws by locating in states with more lenient regulations.
- States like Delaware and South Dakota allow higher interest rates due to relaxed usury laws.
What Is the Legal Rate of Interest?
The legal rate of interest sets a cap on how much lenders can charge, helping prevent excessive or usurious rates that could harm borrowers. Usury laws and their penalties vary widely by jurisdiction, adding complexity to how these limits are applied, and some lenders, such as credit card issuers and national banks, can sidestep state caps through incorporation practices.
Breaking Down the Legal Rate of Interest
An interest rate that exceeds the legal rate of interest is classified as usury. There are usually stiff penalties for usury in most states, such as fines or even the forfeiture of principal and/or interest. The legal rate of interest can also be classified as the highest rate that lenders can charge for any legal claim that can be enforced in a court of law.
In the United States, individual states are responsible for setting their own interest rate laws. Although this type of financial activity could fall under the Constitution’s commerce clause, Congress has not traditionally focused on usury. The government considers the collection of interest payments through violent means a federal offense.
How States Apply Legal Rate of Interest Laws
Each state may set a legal rate of interest through their respective laws. For example, New York set its interest rates quaterly. Delaware’s legal rate of interest is 5% above the Federal Reserve rate, which makes it subject to fluctuations.
In addition to these limits, each state typically sets separate general usury limits that may be higher. New York’s limit is 16% for civil usury and 25% for criminal usury. Banks and other providers of financing who do business in a state could be subject to that jurisdiction’s legal rate of interest.
There are certain exceptions and circumstances that may let lenders charge rates in excess of a jurisdiction’s legal rate of interest. Customers can choose to waive this protection when they apply for financing. Many lenders and financiers may require such an agreement to be signed by their customers to receive any financing.
The language that grants the company the right to charge higher interest rates may be included in the terms of service. Agreeing to receive financing at the interest rate assigned by the lender could override the protections that a legal rate of interest offer whether or not the customer later attests to fully understanding her rights.
Important Considerations for Legal Rates of Interest
Lenders might be able to bypass a legal rate of interest through similar methods used to circumvent usury laws. For instance, credit card providers are allowed to charge interest rates based on the state where the company is incorporated rather than the states where their customers live. The lender might choose to incorporate in a state such as Delaware that offers more relaxed usury laws than other states.
Credit card companies typically have the option of charging interest rates that are allowed by the state where the company was incorporated rather than follow the usury laws that apply in the states where borrowers live. Nationally chartered banks similarly can apply the highest interested allowed by the state where the institution was incorporated. By incorporating in states such as Delaware or South Dakota, lenders have historically benefited from greater leeway allowed in those states’ relaxed usury laws.
The Bottom Line
The legal rate of interest caps what lenders can charge, and exceeding it is considered usury, which can lead to penalties such as fines or loss of interest or principal.
Because each state sets it own limits, and some lenders incorporate in states with more lenient rules, protections vary widely, and borrowers should understand that certain contract terms may reduce the safeguards they expect.