The appellants/borrowers executed a promissory note and a mortgage in favour of the respondents/lenders, both in the same principal amount. The documents related to a single loan.
Despite relating to the same loan, the note and the mortgage had some differing features. Of particular relevance on appeal, the note and mortgage had different terms for interest upon default. They both contemplated interest at 0.75 per cent per annum before default. However, after a default, the note called for an increase in the interest rate to 10 per cent from 0.75 per cent. Unlike the note, the mortgage did not contain an interest escalation provision.
The mortgage also contained provisions for various fees and charges not found in the note, including non-sufficient funds, late payment, and missed payment fees.
The borrowers defaulted on the loan, and the lenders sued them under the mortgage for: i) the principal, ii) interest at a rate of 0.75 per cent, iii) three months’ interest under Ontario’s Mortgages Act, and iv) possession of the property.
The lenders obtained default judgment, but it was ultimately set aside. The lenders subsequently amended their pleading to include a claim for payment of the principal under both the note and the mortgage, as well as interest at a rate of 10 per cent (in accordance with the interest escalation provision under the note) and administration fees for each late payment.
The lenders successfully obtained judgment on their amended claim. The borrowers appealed.
The central issues on appeal were:
• whether the motion judge erred by awarding interest under the note and the mortgage at the rate of 10 per cent rather than 0.75 per cent per annum; and
• whether the motion judge erred by awarding the late payment charges and default fees.
The borrowers submitted that the interest escalation provision in the note offended s. 8 of the federal Interest Act and that the appropriate rate is 0.75 per cent (not 10 per cent) per annum. The lenders, conversely, argued that s. 8 of the Interest Act had no application to the note because the note, unlike the mortgage, was not secured by a charge on any real property.
Section 8 of the Interest Act creates an exception to the general rule that lenders and borrowers are free to negotiate and agree on any rate of interest on a loan.
Section 8 provides:
(1) No fine, penalty, or rate of interest shall be stipulated for, taken, reserved or exacted on any arrears of principal or interest secured by mortgage on real property or hypothec on immovables that has the effect of increasing the charge on the arrears beyond the rate of interest payable on principal money not in arrears.
(2) Nothing in this section has the effect of prohibiting a contract for the payment of interest on arrears of interest or principal at any rate not greater than the rate payable on principal money not in arrears.
Justice Eleanore Cronk, writing for the panel, allowed the appeal on the central issues described above.
Cronk concluded that the arrears of principal and interest, whether under the note or the mortgage, are part of the same transaction and effectively “secured by a mortgage on real property.”
Therefore, s. 8 applies to both the note and the mortgage. As a result, the interest escalation provision contained in the note offends s. 8 of the Interest Act because it has the effect of increasing the rate of interest on arrears “beyond the rate of interest payable on principal money not in arrears” for a loan secured by a mortgage.
Since the 10-per-cent interest escalation provision is unenforceable, the court held the only enforceable interest rate agreed on by the parties is 0.75 per cent.
The appeal court similarly held that 0.75 per cent was the appropriate interest rate for the three months’ interest payment under the Mortgages Act, as well as post-judgment interest.
With respect to the late payment charges and default fees, Cronk held that in the absence of evidence that the charges in question reflect “real costs or actual administrative costs or otherwise,” then the fees were “fines or penalties” and offside s. 8.
No such evidence was before the court as to whether the lenders actually incurred any costs or expenses related to the late payments charges; therefore, these late payment charges and default fees were set aside.
The decision is a helpful one for lawyers advising creditors and debtors alike. The key takeaways here are:
• Where arrears of principal and interest are secured by a mortgage on real property, s. 8 applies to any related debt instruments, not just a mortgage; and
• Lenders must be prepared to justify any late payment charges, administrative expenses, and default fees, lest they be set aside as offending s. 8. This will be true even if the parties expressly agreed to charge terms, which contemplated these fees. Lenders, and their counsel, may also want to examine their form of mortgage commitment and charge to ensure that fees are structured in a way to optimize the chance of their recovery.
Jeffrey Larry is a partner and Lindsay Scott is an associate with Paliare Roland Rosenberg Rothstein LLP in Toronto.