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Monetary Policy Interest Rates

Lawful Rate of Incentives Definition

By Adam Hayes

Updated January 14, 2021

Read by Eric Estevez

What Is the Legal Rate of Interest?

It is considered to be the highest rate of interest that can be legally charged for any type of debt, and to which lenders is required to adhere. This rate is applicable to all types of debt. However, certain types of debt may carry a higher legal rate than others. For instance, the legal amount for a payday lender could be more than the limit set by law for a student loan. The limit is set to prevent lenders from charging borrowers excessive interest rates.

The most important takeaways

Legally, the rate for interest can be considered to be the maximum amount of interest which can be legally charged on any kind of debt.

Certain types of debt could have a higher legal rate than another.

The limits are set to stop lenders from charging borrowers excessive interest rates.

A rate of interest that exceeds the legal rate of interest is referred to as usuary, for which there are stiff penalties in many states.

Every state has a lawful rate of interest as well as usuary rates in their own laws.

Definition of a Loan Shark

Understanding the Legal Rate of Interest

An interest rate that is greater than the rate allowed by law is known as usury. There are usually severe penalties for usury across all states, including fines or even the forfeiture of the principal amount and/or interest. The rate of interest that is legal is also referred to as the highest rate that lenders are able to charge for any legal claim that can be enforced in a court of law.

The United States, individual states are responsible for setting their own interest rate laws. While this kind of financial activity may fall under the commerce clause of the Constitution, Congress has not traditionally focused on usury. The government considers the collection of interest payments with violent means to be as a federal crime.

What is the legal rate of Interest is Applied Different Jurisdictions

Every state can 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%1 above the Federal Reserve rate, which means it is subject to fluctuation.

Alongside these limitations, each state usually has its own general usury limit that could be higher. New York’s limit is 16%2 for civil usury and 25%3 for criminal usury. Banks and other providers of financing who conduct business in the state of New York could be subject to that jurisdiction’s legally-enforceable rate of interest.

There are certain exceptions and situations that could allow lenders charge rates that are higher than of a jurisdiction’s legal rate of interest. Customers can choose to waive this protection when they apply for loans. Many lenders and financiers may require an agreement be signed by customers to receive any financing.

The language that grants the business the ability to increase interest rates could be included in the terms of service. If you agree to receive financing at the interest rate that is set by the lender could override any protections an official rate of interest provides, regardless of whether or not the customer later attests to fully understanding her rights.

Special Considerations for the legal rate of interest

The lending institution could be able to bypass a legal rate of interest through similar methods used to circumvent the laws on usury. For example, credit card providers can charge interest rates according to the state in which the business is registered instead of the states in which their customers reside. The lender may decide to incorporate in a state like Delaware which has more relaxed usury laws as compared to other states.

Credit card companies generally have the option of charging interest rates that are allowed by the state in which the company was incorporated rather than follow the laws on usury that are in the states where borrowers live. Nationally chartered banks also have the option to use the highest interest allowed by the state where the company was founded. Through incorporation in states such as Delaware or South Dakota, lenders have traditionally enjoyed greater flexibility allowed in those states’ relaxed usury laws.