Interest Rates In Architects Agreements and Construction Contracts Part 1 - Fixed Interest Rates
Interest Rates You'll Usually Find
Under most architects agreements and construction contracts, interest gets added onto late payments. I can't remember the last time I saw one of these contracts that didn't add interest to late payments and identify the rate of that interest. But almost as often I notice problems with how the rates are set. The two most frequent problems:
- Fixed interest rates. They could turn out to be too high. Or too low.
- Floating interest rates where the floating rate index is difficult, or impossible, to identify.
Whether fixed or floating, the interest rate you find in architects agreements and construction contracts is usually simple interest, not the more complex, and suspect, compound interest. In most cases it's better to stick with simple interest.
Fixed Interest Rates - The Virtue of Simplicity
Today we'll focus on fixed interest rates. In the next post we'll focus on floating rates.
Fixed rates offer a simple solution. It's easy to identify, never changes, and it's easy to calculate how much interest to add. Simple is usually good. But Albert Einstein said "everything should be made as simple as possible, but not one bit simpler." Sometimes the simplicity of a fixed interest rate is just too simple. When?
- When the amounts of money are large - $250,000 and up.
- When there is a long time between when (1) you set the interest rate and (2) interest starts getting added to a late payment.
With smaller amounts of money, changes in interest rates have to be really dramatic before they start to make a noticeable difference. But just 0.10% can make a huge difference when dealing with hundreds of thousands or millions of dollars.
If interest rates go up, an unpaid architect is essentially lending money to a late paying owner at below market rates. At the same time, that architect is probably borrowing money at higher rates to fund operations. The difference between those interest rates is another cost the architect must absorb and it cuts into their ever slimmer profit margin.
If interest rates go down, a late paying owner over-pays interest to the architect. The interest the owner pays not only compensates the architect for the lost use of money and the cost of borrowing it elsewhere, the architect collects extra interest. By making money from the extra interest, the architect's income now comes not only from fees for professional services and reimbursable expense mark-ups, but from charging interest too. Like a bank.
Interest rates always change. And with the U.S. government borrowing billions more dollars, and non-U.S. investors holding large portfolios of U.S. government bonds they could sell off at any time, odds are that interest rates are going to become a lot more unpredictable and they're going to go up. They have to; interest rates can't go down much further.
Conclusion
So, if the amounts are small and the time periods are short, the simplicity of a fixed rate often makes up for the lack of precision. But large amounts of money and long periods of time usually call for something else - a floating interest rate.
But floating rates have problems too. We'll talk about that in the next post.
Construction Law Today is a legal blog about construction contracts, disputes, finance, and the people whose job it is to deal with them.
