You can charge a late payment fee when the due date has passed, and the check isn’t in the mail. Just make sure you follow a few simple guidelines and your state’s laws.
Sometimes clients can drag their feet and pay your invoice on their own schedule without regard to the payment due date. Such late payments can disrupt your cash flow and accounts receivable and cause you to spend valuable time following up with the client about the payment. To help avoid these disruptions and limit follow-up time, your business should have a plan for dealing with late payments, namely, a late payment fee policy.
What Is a Late Payment Fee?
A late payment fee is an amount added to the balance of an invoice when it isn't paid by the due date. Companies use late fees to compensate for:
- the interest they lose when the money isn't in their bank account on time, and
- for the value of the time they spend dealing with overdue payments (monitoring the accounts and sending repeated requests for payment, for example).
As an independent contractor or business owner, you're legally allowed to apply late payment fees when clients miss a due date for payment. But you must first have a written agreement in place that outlines your late payment policies, and you'll need to keep your fees within the limits set by the laws in your state.
When Can You Charge a Late Fee?
When a client misses a due date to pay for goods or services, you, the business owner, become a de facto creditor. You're extending credit to your client and giving them more time to pay their debt. Just as with any credit transaction, you must spell out the terms in advance and in writing in order to legally impose the added charge.
Your agreement should detail the fee for services and the due date for payment, usually written as, "net 30, 60, 90 days," and so on. In business, "net" is a credit term that means the period of time allowed for paying an invoice. Net terms are calendar days. Your agreement should say the late fee amount that'll be added if payment isn't received by that date. Both you and your client should sign the agreement.
On the invoice you send to your client, you should clearly state your payment terms and late fee.
Your invoice should include:
- the date of the invoice
- the balance owed
- the terms of payment, such as ‘net 30 days', and
- a statement of the late fee charges that will apply, such as: "A 1.5% late payment fee will be added per month for payments not received within 30 days."
The time frame you set for payment is up to you and the arrangement you make with your client. The key point is to specifically state when payment is due in both your agreement and invoice.
How Much Can You Charge for Late Payments?
Before you set a late fee, it's important to understand the purpose of late fees. Under the law, you can't use a late payment fee to penalize or punish your client for not paying on time, or as a way to collect additional revenue. You can charge only an amount that covers the costs and losses you incurred as a direct result of the late payment, and those costs must be reasonable. For instance, the late fee can cover costs such as:
- any interest you would've earned if the payment were deposited in a bank account in a timely fashion, and
- the time and supplies required to collect payment, such as making phone calls, and printing and mailing additional invoices.
Typically, late payment fees average 1% to 1.5% of the invoice amount. You can express the late fee as a percentage or a flat fee as long as the amount you charge doesn't exceed your state's limits. Flat late fees are appropriate when you know the amount of the ultimate invoice at the time you sign the contract because you can easily make sure that the fee doesn't exceed state law limits. On the other hand, if you'll be paid by the hour and don't know in advance how many hours you'll work, you could have a hard time coming up with a flat fee that passes legal muster.
Though the amount allowed by each state varies, limiting your fees to a maximum of 10% per year should generally keep you from running afoul of state laws.
Even when you keep your fees to the state maximum allowed, however, remember that fairness is key in determining late fees. If your client takes you to court to challenge the fees you've imposed and wins, you can end up paying more in penalties than the fee you originally charged.
How to Calculate Late Fees
Let's say you want your late fee charges to account for the interest you would've earned had the invoice been paid on time. So you decide to charge a monthly late fee. Follow these steps:
- Divide the current interest rate by 12 to determine the monthly interest charge.
- Multiply the total by the amount of the invoice.
Let's look at an example based on an interest rate of 2% for an invoice of $10,000 that's 30 days past due.
- Step one: .02 (the interest rate) ÷ 12 (months) = .0016 (monthly interest rate).
- Step two: .0016 (monthly interest rate) x $10,000 (invoice amount) = $16.66 (the late fee).
If another month passes, and your client still doesn't remit payment, you'll have to add another $16.66 to the next invoice. Remember to detail the time the fee represents (30 days, 60 days, and so on) on the invoice.
The example above adds a simple interest calculation to the invoice charges. You can also compound the interest if state law and your fee agreement allow, as long as the sum owed doesn't exceed your state's annual limit or become unreasonably large.
While $16.66 might not seem a sufficient deterrent, adding any late fee can encourage your client to move your invoice to the top of the pile and pay it promptly.
What to Do Before You Charge a Late Fee
Just because you're within your rights to charge clients who don't pay you on time, doesn't mean you should in every instance. Before enforcing your policy, consider whether charging the fee is worth jeopardizing your business relationship.
Try phoning your customer to discuss the reasons for the missed payment.
- If it's a first offense, forgiving the incident might go a long way to preserving your business relationship.
- If it's an issue with the work you delivered, focus on resolving the issue instead of pursuing a late fee.
- If your customer is having financial difficulties, you can try to work out a payment plan.
If your customer is a repeat offender, doesn't give you a reason for the overdue payment, or dodges your calls, it's time to put your late payment policy into motion.
First, check your service agreement or contract to make sure the amount you've calculated is consistent with the terms outlined for late payments.
Next, send a letter or email reminding your client when payment was due and the amount of the new balance including the late fee. Attach a copy of the original invoice, and explain that the late payment fee will be added for each month (or day or week) the invoice goes unpaid.
Include contact information and ask your client to contact you with any questions. You can also offer to set up a payment plan if you believe financial difficulties might be at the root of the overdue payment.
If you still don't receive payment, you should continue sending invoices with updated late fee charges. You'll have to decide at what point you move from invoicing to more formal collection methods. (For more on collecting overdue payments, read our article on what to do if a client won't pay.)
How to Avoid Charging Late Fees in the First Place
It's a good idea to send your client a reminder (by telephone or email) about a week before payment is due. If the late payment was an oversight, a staffing issue due to vacations, or it was lost in a pile of paperwork, a reminder can jog the client into action.
You can also incentivize your client to pay early by offering a small discount, sometimes called a prepayment or cash discount. If your margins allow, consider offering a small percentage off the invoice for clients who pay within a shorter period than required. Make sure, however, that your discount isn't so large that it looks like you're trying to exceed the state limit on late fees when clients don't pay early. Courts might look at the difference between the full invoice amount and the discount amount and decide that the full amount was inflated to include a disguised, illegal late fee.
For example, if you require payment within 30 days, discount the balance by 1% or 2% if the customer pays within 15 days. Make sure that you document the discount in your service or purchase agreement and on your invoice to avoid misunderstandings about the terms.
Another option is to request pre-payment for services in full or part to reduce the impact of late payments on your cash flow.
Enforcing late fees on clients is never fun. But overdue invoices are a problem faced by almost every business. Creating an action plan early can help you resolve late payments quickly, and potentially avoid some instances of overdue invoices altogether.
