You held up your end of the deal – rendering services or delivering goods – but now your client is ignoring the invoice. It’s an unpleasant situation, with implications for your cash flow and customer service. You may have sent second notices, statements or demand letters, but nothing is working. How can you effectively collect past-due invoices and prevent late payments in the future?
The answer is to make paying late painful for the client by charging late fees or interest on unpaid balances. This helps fill some cash flow gaps and pays for extra collection efforts. It also incentivizes clients to pay on time to avoid paying more down the line for their procrastination.
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What are interest fees?
An interest fee is additional money the client owes you over and above the original invoice amount if they pay late. The interest rate is a percentage of the unpaid balance that accumulates every month that the invoice remains unpaid. The interest rate is usually displayed as an annual rate, for example, 10 percent. But since it accrues monthly, the amount charged is that annual rate divided by 12. So a 10 percent annual interest rate would be 0.83 percent each month.
Interest fees usually compound to serve as a more substantial disincentive for late payments. This means that if the interest is charged in month two, it is added to the balance due. If the customer still hasn’t paid by month three, the monthly rate is applied to the new balance. For example, let’s say you invoice a client $200 with net 30 terms. The first month comes and goes with no payment. Now, you would apply the 0.83 percent to the $200 balance.
$200 x 0.0083 = $1.66 This is the interest fee for month one.
At the end of month two, the customer now owes:
$200 original balance + $1.66 interest = $201.66
If the customer does not pay in month three, the interest is applied to the new balance:
$201.66 x 0.0083 = $1.67 interest
At the end of month three, the customer now owes:
$201.66 + $1.67 = $203.33
Since the interest fee is based on the amount owed, the amount of the penalty keeps increasing the longer it remains unpaid. While it doesn’t look like much, it can accumulate quickly, especially if the original invoice amount is large. Customers will feel pressure to pay as they see the amount owed ballooning.
What are late fees?
Late fees are another financial penalty for late payment. Rather than multiplying the balance by an interest rate, you would charge a flat amount when the payment is late. Most late fees are between $25 and $50. For example, you may charge a late fee of $25 when an invoice is not paid according to the terms. Some companies use a percentage of the invoice amount to calculate the late fee, but this amount does not compound; it would be the same amount each time.
If the customer continues not to pay, you can assess multiple late fees, as long as these terms were clearly laid out in your written agreement before the sale and on your invoices. They must also comply with state law. You can also set the frequency at which late fees will be assessed, such as daily, weekly, monthly or quarterly. State laws often have a cap on the total amount of allowable late fees, which are usually tied to the invoice amount.
Since late fees are generally larger amounts that accumulate more quickly, they can be a stronger incentive for prompt payment than interest fees. For example, on the same $200 invoice as outlined above, a monthly late fee would work as follows after the first month of nonpayment:
$200 original invoice amount + $25 late fee = $225 new balance at the end of month two
If the customer does not pay in month three, another late fee is assessed:
$225 balance + $25 = $250 new balance at the end of month three
However, if your state law caps interest and late fees to no more than 10 percent of the original invoice, it is better to go with interest fees. This is because $50 in late fees is more than 10 percent of $200 and charging this would be illegal.
You can use top accounting software to calculate and track both interest and late fees.
How do you charge interest and late fees on unpaid invoices?
You can charge interest on unpaid invoices if you stay within the bounds of the law. Late fees are standard practice in many industries. Nevertheless, you should let your client know your intention in advance. The key to charging interest is to do it legally and without losing sight of your goals. Collecting the original invoice amount and maintaining a good relationship with the customer should always be your primary objectives.
When charging a late fee or interest, ensure the original contract the client signed states any fees or interest charges that will be assessed, when they will be assessed, whether they compound and if there is a grace period. A grace period is a time after the invoice is due in which you don’t charge interest or fees as long as payment is made in that window. For example, if an invoice is due on the first of the month, the grace period may be an additional 10 days. That way, you avoid alienating your client if payment is just a few days late.
There are three essential things to know:
- Assess late fees only if a written agreement outlines this option. Be sure to include this phrase: “Accounts not paid within terms are subject to a ___ percent monthly finance charge.”
- Don’t charge more than 10 percent interest per year. Some states restrict the amount you can charge in late fees, but you’re likely safe if you cap rates at 10 percent.
- Do not describe the interest or late fee as a “penalty,” since this could imply that you are attempting to punish the client rather than cover the additional costs involved in collecting the money you are owed. If you have to go to court, this could hurt you.
Tip: Include your interest or late fee policy on all invoices you create, statements and payment reminders.
When to charge interest or late fees (and when you shouldn’t)
Do charge interest or late fees when:
- You are in a cash crunch. If your business needs cash now and you have accounts receivable, then charging interest or late fees is a necessity.
- You have clients who consistently pay late. If clients are lackadaisical about paying, they may not view you as a professional business. Instituting an interest rate or late fee policy will hold them accountable.
- You have clients who deliberately pay late. Some clients just take advantage of business owners, trying to get away with stringing your payment for as long as possible. A late fee or interest policy will make them behave or weed them out.
Did you know? If a client refuses to pay, as a last resort, you can file a lawsuit and take them to small claims court for invoices less than your state’s limit or sue in regular court for larger invoices.
Don’t charge interest or late fees when:
- The payment was late because the customer was dissatisfied. If clients feel the work or product needs to be revised, they may hold money back until it is corrected. Now is not the time to play hardball but to resolve the customer service issue. That may require you to offer a discount, not tack fees on.
- The client was unaware of the policy. This is where communication upfront is vital. Outline your policy in writing before the sale, and include reminders on each invoice. This helps ensure the client isn’t given an unpleasant surprise. If they claim that they didn’t know, consider giving them a pass but let them know that the late fee or interest will be assessed going forward.
- The payment is late because of a disaster or personal tragedy. It is in poor taste to assess late payment penalties when a client’s business has been impacted by a natural disaster, like a hurricane or flood, or is grieving the loss of a close family member. This is the time to offer condolences and empathy.
Alternatives to charging interest and late fees
Charging interest and late fees are just some of the ways to collect your invoices. Other options include:
- Contacting the customer to see what is holding up the payment. It could be something that is easily fixed. Reaching out shows empathy while still getting the message across that you expect payment. You can use this opportunity to gently remind the client that nonpayment will incur interest or fees.
- Waving a carrot instead of a stick by offering a discount for either full payment upfront or within 30 days. Sometimes incentives to pay early or on time can be more effective than threats of fees and interest charges.
- Collecting payment up front rather than after the product or service has been delivered. In this case, the incentive to pay upfront is receiving the goods or services and no money is lost if the client fails to pay.
- Offering a payment plan if the client is having financial difficulties. This offers you the advantage of providing empathy while also collecting at least some of what is owed. It is expected that you will charge interest on the payment plan, although you do not have to do so.
Tip: Send electronic invoices with a link to a secure online payment page. The immediacy and convenience of this option can prompt disorganized clients and procrastinators to make payments.
Charging interest and late fees are a viable collection tactic, speeding up your collection process and compensating you for the costs of interrupted cash flow and additional collection activity. But be sure to do it correctly, or you could alienate customers and get in trouble with the law.