How to Charge Interest and Late Fees on Unpaid Invoices

What are interest fees?

An interest fee is additional money you charge a client 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 the invoice remains unpaid. The interest rate usually is displayed as an annual rate, for example, 10 percent. However, 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’s added to the original balance due. If the customer still hasn’t paid by month three, the monthly interest rate is applied to the new balance. 

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For example, let’s say you invoice a client $200 with net 30 terms. The first month comes and goes with no payment. Now, with a 10 percent annual interest rate, you would apply the 0.83 percent to the $200 balance:

$200 x 0.0083 = $1.66 = 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 rate is applied to the new balance:

$201.66 x 0.0083 = $1.67 = the interest fee for month two

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 penalty amount keeps increasing the longer the balance remains unpaid. While it doesn’t look like much in the above example, interest fees can accumulate quickly, especially if the original invoice amount is significant. Customers will feel pressure to settle their debt with you as they see the amount owed ballooning. 

What are late fees?

Late fees are another financial penalty you can charge for late payments. Instead of multiplying the balance by an interest rate, you would charge a flat amount when a payment is late. Most late fees are between $25 and $50. For example, you could charge a late fee of $25 when an invoice is not paid by its due date. Some companies use a percentage of the invoice amount to calculate the late fee, but this amount doesn’t compound — it would be the same amount each month.

If the customer continues not to pay their balance, you can assess multiple late fees as long as these terms were laid out in your written agreement before the sale, are on your invoices and comply with state law. You can set the frequency at which late fees will be assessed, such as daily, weekly, monthly or quarterly. Some states cap the total amount of allowable late fees, which are usually tied to the invoice amount. See the maximum late fees each state allows below.

Since late fees are generally larger amounts that accumulate more quickly than interest fees, they can be a stronger incentive for prompt payment. 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

“From my experience … I’ve seen that combining both [interest and late] fees works best for encouraging timely payments,” said Andrew Lokenauth, a fractional chief financial officer who is also the founder of Fluent In Finance and TheFinanceNewsletter.com.

However, if your state law caps interest and late fees to no more than 10 percent of the original invoice, it’s better to go with interest fees. This is because, with this example, $50 in late fees is more than 10 percent of $200, so charging this would be illegal.

Best practices for charging interest and late fees

When you issue an invoice with a late fee, you should include an explanation of the charge. (Image credit: business.com)

The key to charging interest or a late fee 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. The experts we spoke with recommend following the best practices below.

1. You must have a written agreement to assess interest fees or late fees: Although these fees are standard practice in many industries, you should let your client know your intention in advance. Ensure the original contract the client signed states any fees that will be assessed, when they will be assessed, whether they compound and if there is a grace period. “This saves headaches,” said Lokenauth, who admitted he “learned this one the hard way.”
2. Don’t charge more than 10 percent interest per year or excessive late fees: You can charge interest on unpaid invoices if you stay within the bounds of the law. Some states restrict the amount you can charge in late fees, but you’re likely safe if you cap rates at 10 percent. “Make sure your late fee amounts are reasonable and proportional to the debt,” advised Lokenauth.
3. Don’t call interest or late fees a penalty: Do not describe the interest or late fee as a “penalty.” This could imply that you are attempting to punish the client instead of covering the additional costs involved in collecting the money you’re owed. If you have to go to court, this could hurt you.
4. Offer 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 a few days late. “I’ve found this builds goodwill,” Lokenauth said.
5. Immediately alert clients when their payments are past due: “Consider a tiered approach before charging fees — gentle reminders first with a projected fee, then formal notices with fees,” recommended Denym Bird, co-founder of Paidnice. Both Bird and Lokenauth stressed the need to be “consistent” in enforcing fees. 
6. Take advantage of modern payment technology: Bird said business owners should use invoicing automation tools “to calculate and apply fees accurately.” But it’s not about streamlining processes just for yourself; you should for your clients as well. “Make it easy for customers to pay by providing multiple payment options,” said Bird.

When and when not to charge interest and late fees

Do charge interest or late fees when:

• You are in a cash crunch: If your business needs cash now, charging interest or late fees on unpaid balances is a necessity for your accounts receivable process.
• You have clients who consistently pay late: If customers are unconcerned about paying for services rendered, it may be because they don’t view you as a professional business and don’t see any urgency to settle up. Instituting an interest rate or late fee policy will hold them accountable. 
• You have clients who deliberately pay late: Some clients take advantage of business owners and try to get away with holding out your payment for as long as possible. A late fee or interest policy will incentivize them to stop their delinquency.

Don’t charge interest or late fees when: 

• The payment was late because the customer was dissatisfied: If clients feel the work completed or the product received needs to be revised, they may hold their payment back until the issue is corrected. Now is not the time to play hardball; instead, you should work to resolve the customer service issue. That may require you to offer a discount, not tack on late fees.
• The client was unaware of the policy: This is where communication upfront is vital. If you outline your policy in writing before the sale and include reminders on each invoice, it helps ensure the customer isn’t surprised when they see the add-on charges on subsequent bills. If they claim they didn’t know about the policy, 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’s in poor taste to assess late payment penalties when a client has been impacted by a natural disaster, such as a hurricane or flood or if they’re grieving the loss of a close family member. This is the time to offer condolences, empathy and a flexible payment schedule.

Laws governing interest and late fees

You should anticipate some customers questioning whether your interest or late fee charges are legal. Whether they are depends on whether you’re following the law.

“The legality of these fees is primarily governed by state laws, particularly those related to usury and contract law,” explained Ben Trigg, founder and CEO of Payello. “Usury laws set a limit on the interest rate that can be charged and contract law requires you to inform the customer about your fees.”

More than a dozen states also have laws that cap how much you can charge in late fees (see chart below). For those that don’t, it’s vital to “ensure that your fees are reasonable and not considered punitive,” Trigg said. 

“Excessive fees could be challenged in court,” he noted. “The Fair Debt Collection Practices Act is also something to be aware of, especially when dealing with personal debts. If you contact a debtor too much or in an extreme fashion, it may be considered harassment.”

Maximum invoice late fees by state 

Below, find a state-by-state breakdown of maximum late fees and grace period requirements to ensure you comply with the law in your company’s state.

Alternatives to charging interest and late fees

There are other ways to collect on your unpaid invoices besides charging interest and late fees. You may want to consider the alternative options below.

• Communicating with the customer to see if there is a problem: Contact the customer to see what’s holding up their payment. “Missed payments aren’t always on purpose,” Trigg pointed out. It could be something fixed easily and reaching out shows empathy while still getting the message across that you expect to be paid. You can use this opportunity to gently remind the client that nonpayment will incur interest or fees.
• Providing payment incentives: Wave a carrot instead of a stick by offering a discount for 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. Bird revealed, “Our data across millions of invoices paid since 2022 shows that a prompt payment discount, such as 2 percent if paid within 10 days, is the most effective way of getting cash into the bank well ahead of your due date.”
• Collecting payment upfront: Asking customers to pay upfront eliminates any potential nonpayment issues. You can also require a deposit instead of asking for full payment. “This changed my business completely,” Lokenauth told us. It’s up to you to decide if an upfront payment or deposit is more appropriate for your company, but business.com’s guide to requiring a deposit and upfront payments can help.
• Offering payment plans: Consider offering a payment plan if the client is having financial difficulties. You’ll show empathy while collecting at least some of what is owed. Payment plans usually include an interest charge, although you don’t have to add one. You can also provide a payment plan regardless of any financial hardship; even customers with the means to pay in full may prefer the option to pay in installments.
• Selling outstanding invoices: If you don’t think interest or late fees will prompt customers to pay their overdue balances and you can’t keep waiting to get paid, you might want to opt for invoice factoring. A lender will purchase your outstanding accounts receivable and give your business funds in exchange. Bird recommended this option especially if you need to “improve your cash flow.” Several highly rated business loan providers facilitate invoice factoring and a similar option known as invoice financing.

Interest and late fee charges are viable collection tactics that speed up the debt collection process and compensate you for the costs of interrupted cash flow and additional collection activity. As long as you do it correctly and don’t alienate customers or get in trouble with the law, you might find it preferable to the alternatives above.

“But most important of all,” Bird said, “is to set up a strong receivables process from the get-go, with … payment reminders before invoices become overdue in the first place.”