Default Interest Rates on Mortgages Structured as Discounts for Timely Payment Prohibited by Section 8 of Interest Act
May 31, 2016
Section 8 of the Interest Act (Canada) (Section 8) prevents lenders from charging a higher rate of interest after default on a mortgage of real property than that charged prior to default.
In other words, if a mortgage with a rate of interest of five per cent during its term is increased to 10 per cent should the borrower fail to pay the amount due at maturity or should the borrower go into default, such increase contravenes Section 8. This section is not limited to interest, but also includes fines, penalties and lump-sum bonuses where the effect is increasing the charge on arrears beyond the rate of interest payable on the principal before a default.
In its recent majority decision in Krayzel Corp. v. Equitable Trust Co. (Krayzel), the Supreme Court of Canada (SCC) found that rate increases triggered by default under a mortgage infringe Section 8, whether or not the default interest rate is structured as a discount instead of a penalty.
In Krayzel, when the borrower was unable to pay out its mortgage loan on the scheduled maturity date, the borrower and lender entered into multiple mortgage amending agreements, extending the loan’s term and increasing the interest rate. The second mortgage amending agreement provided for an annual interest rate of 25 per cent, but also contemplated discounted monthly interest payments at a significantly lower “pay rate” so long as there was no default under the loan.
In determining whether the arrangement described above offended Section 8, the SCC considered whether there is a distinction between:
- Terms imposing, by way of penalty, a higher rate upon default; and
- Terms reserving, by way of discount, a lower rate in event of no default
The majority of the SCC held that Section 8 applies equally to mortgage terms providing for “discounts”, or incentives for performance, and penalties for non-performance, whenever the effect of these terms is to increase the charge on arrears beyond the rate of interest payable on principal money not in arrears. As such, the annual interest rate of 25 per cent set out in the second mortgage amending agreement was held to be void, and the interest rate in force was deemed to be the lower “pay rate.” In their dissent, three of the nine judges of the SCC disagreed.
The SCC’s divided decision in Krayzel suggests that until there is statutory reform, there will continue to be some commercial uncertainty surrounding the interpretation of Section 8. In the meantime, commercial lenders must take notice of the SCC’s application of Section 8 to discounts and incentives as well as penalties, when structuring real estate loans. Dependent on the structure of the mortgage loan, it appears that offering a discount to a borrower for making timely payment as opposed to penalizing them for not paying on time offends Section 8.
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