Usury

Usury refers to the practice of charging interest on a loan that exceeds the maximum rate permitted by law. Every U.S. state has some form of usury statute, though the specific caps, exemptions, and penalties vary widely. For secondary market note investors, usury is a critical due diligence issue — a loan with an interest rate or default rate that violates the applicable state's limits can be partially or entirely unenforceable, turning what looked like a high-yield investment into a legal liability.

How Usury Laws Vary by State

There is no single federal usury limit for residential mortgage loans. Each state sets its own rules, and the differences can be dramatic:

These are simplified summaries — the actual statutes contain layers of exceptions based on lender type, loan purpose, loan amount, and whether the loan is a first or second mortgage. The governing law clause in the promissory note determines which state's usury statute applies, though courts may look to the borrower's state of residence or the property's location if the choice-of-law provision is challenged.

Federal Preemption

Federally chartered banks and thrifts are generally exempt from state usury caps under federal preemption doctrines. The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) effectively preempted state usury limits for most first-lien residential mortgages made by federally regulated lenders. However, this preemption does not extend to all lenders:

• Private lenders creating owner-financed notes are typically subject to state usury laws.
• Hard money lenders may or may not be exempt depending on their licensing and charter status.
• Non-bank originators must comply with state lending laws, which often include usury limits.

When a note originated by a federally preempted lender is sold to a private investor, the preemption status may not travel with the loan in every jurisdiction. This creates a gray area that investors should discuss with legal counsel before acquiring high-rate notes.

Usury Risk in Note Investing

Usury exposure arises in several common scenarios for note investors:

• High contract rates — A promissory note with a contract rate of 12-15% may be perfectly legal if originated by a licensed lender in one state but usurious if the governing law points to another state with a lower cap.
• Default rate provisions — Many notes include a default rate that kicks in when the borrower stops paying — sometimes 5-6 percentage points above the contract rate. If the combined rate exceeds the state's usury ceiling, the entire interest provision (or in some states, the entire loan) may be void.
• Late fees and charges — Some states treat excessive late fees, prepayment penalties, and other charges as disguised interest. If these charges push the effective rate above the usury limit, the lender may face penalties.
• Accrued interest on non-performing notes — When a non-performing loan has years of unpaid interest accruing at a usurious rate, the total amount claimed may be challenged by the borrower.

Consequences of a Usury Violation

The penalties for usury vary by state but can be severe:

• Forfeiture of interest — The lender loses the right to collect some or all interest on the loan.
• Voiding the loan — In some states, a usurious loan is entirely unenforceable, meaning the lender cannot recover even the principal.
• Treble damages — Certain states allow the borrower to recover two or three times the excess interest charged.
• Criminal penalties — States like New York classify extreme usury (above 25%) as a criminal offense.

For a note investor, these consequences mean that a borrower facing foreclosure on a usurious note has a powerful affirmative defense. Courts that find a usury violation may dismiss the foreclosure action, award the borrower damages, and require the lender to refund excess interest already collected.

Protecting Against Usury Risk

During due diligence, investors should verify the contract rate and any default rate against the usury ceiling of the state whose law governs the note. When acquiring notes with rates above 10-12%, consult with an attorney licensed in the relevant state. If a usury issue is identified post-purchase, the investor may be able to reduce the rate to a compliant level through a voluntary loan modification — which can also serve as a goodwill gesture that supports a workout with the borrower.