On May 6, 2016, the Supreme Court of Canada decided that a mortgage imposing a higher interest rate in the event of default and reserving a lower rate in the event of no default – whether it's called an incentive, a penalty or a rose – contravenes section 8 of the Interest Act, and is void. The decision doesn't mean that a mortgagee or lender can't offer a borrower an interest rate discount or some relief – but it does mean it must be very careful when drafting it. A mortgage lender that wants to give its clients and borrowers some type of interest rate discount that complies with section 8 must ensure the effect of the performance incentive doesn't increase the charge on the arrears beyond the rate of interest payable on principal money not in arrears.
In Krayzel Corp. v. Equitable Trust Co. The mortgagor granted the lender a mortgage at an interest rate of prime plus 2.875% per annum to secure a $27M loan. The parties subsequently entered two mortgage renewal agreements. The first, effective August 1, 2008, extended the mortgage term by seven months and provided for interest to be calculated at prime plus 3.125% per annum over the first six months of the term, and then 25% per annum over the seventh month. The second, effective February 1, 2009 but retroactive to one month before the first renewal agreement's expiry, provided for:
- Interest to be calculated at 25% per annum.
- The borrower to pay monthly interest at the "pay rate" of either 7.5% or prime plus 5.25% – not the stated per annum rate of 25% – and for the difference between the amounts payable at the 25% rate and that at the lower rate to "accrue" to the loan.
- If the borrower didn't default, the lender would forgive this "accrued interest".
On May 15, 2009, the mortgagor defaulted on the loan; the lender demanded repayment at the rate of 25% per annum. The mortgagor resisted on the basis the mortgage terms infringed section 8 of the Interest Act (Canada) on two basis: first, by a mortgage agreement term imposing a rate increase effective only where the mortgagor defaults by either failing to make prescribed payments at a lower "pay rate" of interest or by paying out the loan upon maturity; or by providing for a higher interest rate triggered solely by mere passage of time. The majority of the Supreme Court of Canada (six to three justices) ultimately decided the term is void and left the lender with a much lower rate of interest:
- Substance over form. In an analysis of section 8 of the Interest Act, what matters is the effect – not the label (whether "interest rate" or "pay rate") – of the charge. The purpose of section 8 is to protect landowners from charges "that would make it impossible for [them] to redeem, or to protect their equity". It prohibits a lender from stipulating for, taking, reserving or exacting three classes of charges – fines, penalties and interest rates – if the effect is to impose a higher charge on arrears than that imposed on the principal not in arrears. And it applies to discounts (incentives for performance) as well as to penalties for non-performance whenever the effect – regardless of the label – is to increase the charge on the arrears beyond the rate of interest payable on principal not in arrears.
- A rate increase – whatever it's called – triggered by default is void. A term imposing a rate increase triggered by default infringes section 8, whether it's cast as imposing a higher rate penalizing default or as allowing a lower rate as a reward for the absence of default. The Court decided the effect of the 25% per annum interest rate under the second renewal mortgage in this case was to reserve a higher charge on arrears than that imposed on principal money not in arrears, and is void. The Court set the rate at the higher of 7.5% and prime plus 5.25%.
- Time doesn't change things. A rate increase triggered by the passage of time alone doesn't infringe section 8 of the Interest Act.
This decision doesn't mean that a mortgage lender can't offer a borrower an interest rate discount or some relief – but it does mean it must be very careful when drafting it. Mortgages imposing a higher interest rate in the event of default and reserving a lower rate in the event of no default – whether it's called an incentive, a penalty or a rose – contravene section 8 of the Interest Act, and will thus be void. A mortgage lender that wants to ensure it complies with section 8 while providing its clients and borrowers with some type of interest rate discount, can only do so if the effect of the performance incentive doesn't increase the charge on the arrears beyond the rate of interest payable on principal money not in arrears.
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