Late payment is a common problem for small businesses, with some choosing to charge late payment fees to deal with it. But is this the right decision?
Late payment is tough in normal times, but especially when times are tough. Not only does it become a financial burden but an emotional one too.
A common solution to deal with invoices past their due date is to charge a late payment fee: An extra charge to a client for not paying an invoice by the payment deadline.
It’s the obvious solution, right? You push the client to pay you now, or they incur more costs further along the line.
But is it that simple? Are there not situations where it’s a bad idea? And once you’ve decided to charge a late payment fee, how much do you charge?
There is, in fact, a lot to consider. This post will explore:
- Why charging a late payment fee can be a good idea
- Guidelines for setting late fees—and when it may be a bad idea
- How much to charge for overdue payments
- How to prevent the need for late payment fees in the first place
Table of Contents
Why Charging Late Payment Fees Can Be a Good Idea
Besides encouraging clients to pay, an overdue payment fee is a good idea for other reasons:
1. You Need the Money—ASAP
Cash flow is an absolute necessity to cover your daily business expenses. One way to keep cash flowing is by charging a late payment fee as an added incentive to get clients to pay up sooner.
While ideally, you could avoid such measures, the mere idea of late payment fees might motivate clients to pay you as soon as they can or at least communicate with you if they’re unable to.
2. It Establishes You as a Serious Professional Who Has a Business to Run
If you don’t include a late fee policy, the perception may be that a client who doesn’t pay you by the due date can repeat this behavior.
3. You Get Paid Before Other Contractors Do
Chances are that if clients aren’t paying you by the payment date, they’re doing the same to other contractors. But if you have stricter late payment policies and kick up a fuss, they’ll move your payment to the top of the pile.
While in principle late payment fees work, there are instances when they’re not a good idea.
Guidelines for Charging a Late Payment Fee
By following the below guidelines, you’ll better understand when it’s suitable to charge these late fees.
1. Confirm if the Work Fulfills the Estimate
Every client is different. Some won’t pay you because, well, they’re bad clients. Others, still, won’t pay because they don’t have the money. But then there are those who aren’t happy with your service. Instead of making a fuss, they vent their anger by not paying you on time.
Including a late payment fee in an invoice may only aggravate the problem. That’s why you must double-check that the work fulfilled the estimate before you invoice.
If it did, the client is most likely satisfied. You can now send your invoice and include payment terms, so there are no surprise late fees. Speaking of which…
2. Make Sure Clients Are Aware of the Late Fee
Nothing burns bridges faster than surprise late charges. Don’t include late payment fees if clients aren’t expecting any. Rather, first establish expectations by:
- Specifying the late fee early in the relationship, in writing, ideally through a contract. And remember: When done in a positive, friendly way, your clients will understand late fees are nothing personal—but something small business owners need to include for protection.
- Including the late charge on all invoices you send and specifying whether it’s a flat fee or a percentage of the invoice amount. Make sure it’s visible—don’t hide it in the fine print. Just as you would be frustrated to encounter surprise late fees buried deep in the terms and conditions, so would your clients.
You can still include late fees if you have not specified the above. Just inform the client in advance, stating that you will have a late payment policy next month.
This way, they can’t act ignorant and can expect all future unpaid invoices to increase in value after a pre-determined amount of time.
And if the client responds asking for justification, you can say that you enforce this late payment policy with all new clients.
3. Know When Forgiveness Is the Better Choice
Just because you have a late fee policy doesn’t mean you have to enforce it on every occasion. For example, a client may be going through a personal challenge—like dealing with bereavement or an unexpected illness.
In other cases, there may be unforeseen circumstances where a lucrative and usually reliable client can’t pay you on time. Evaluate each situation, don’t impose the same late payment policy on everyone, and see if you can find another way to deal with those unpaid invoices.
For instance, instead of charging a late fee, you could offer a payment extension to extend the payment terms from 30 to 60 days. You could even use a payment plan.
A payment plan allows your clients to pay off past-due invoices over time according to a specific payment schedule. These payment plans should outline the minimum amount together with interest charges.
These plans provide payment flexibility, allowing you to tailor payments to your customer needs. Because these plans are more attractive to clients than a full payment—including any late fees—clients are more likely to afford them, which increases your chances of getting paid by the due date.
By highlighting that you’re empathetic with a customer’s circumstances, waiving the late fee, or finding other ways to handle late payments, you can strengthen your relationship with them. This will only contribute toward business success in the long run. Besides being a good business practice, it pays to be human.
How Much Can You Charge for a Late Fee?
Let’s assume you’re considering charging a late fee or have no other option. The next questions you probably have are: How much do I charge for overdue balances? How do I calculate the monthly interest rate? Is there an upper limit? What’s acceptable and what isn’t?
Before we answer these questions, it’s important to reinforce that the purpose of the late fee is to motivate prompt payment and NOT to create an extra revenue stream.
So, make sure the late fee is sufficient enough for clients to act and not too exorbitant that they feel you’re being unfair—especially if they have only missed the payment due date by a couple of days. If anything, it’ll only sour the relationship, and you’ll lose their business.
Okay, with that out the way, let’s get back to it.
The first step is to establish an acceptable level of interest to charge. In the United States, there are different laws for each state.
Familiarize yourself with those.
Once you know the maximum annual interest rate you can charge for a past due invoice, work out the monthly late fee. Just divide the state’s max annual interest rate by 12. For example, if the interest rate is 18%, the monthly finance charge is 1.5% (18/12). On a $5,000 invoice that is 30 days late, a penalty of $75 ($5,000 x 0.015) applies.
Let’s also assume that the payment is 15 days late. It becomes a bit different. Then you can calculate the monthly finance charge by dividing 15/365, multiplying by 18%, and then by the total on the original invoice. It gives you roughly $37.
It’s as simple as that…and charging a late fee with FreshBooks is even simpler. When you create an invoice and add a client, you can set a late fee as a percentage or a flat fee.
How to Prevent the Need for Late Fees
If you want to avoid late payment and having to charge late payment fees in the first place, consider these alternatives:
1. Request an Upfront Deposit of Anywhere From 20-50%
The chances of receiving full payment for an invoice are higher when the client has already paid a deposit. Worst case scenario, the client doesn’t pay the outstanding balance, but at least you have the deposit to cover your costs.
2. Reward Prompt Payment: Offer Discounts to Clients Who Pay Early
For example, provide a 2% discount off the pre-tax invoice for clients who pay in 7 days. Avoid taking the financial hit by bumping up your prices by the discounted amount.
3. Allow Online Payments
The reason online payments are so compelling boils down to convenience and choice.
Firstly, by allowing clients to conveniently pay online directly from an invoice, clients are prompted to pay immediately with no delays instead of the payment falling off their radar or getting lost in their inbox.
Secondly, different customers prefer paying in different ways. For instance, some may prefer to pay via credit card to collect points. By providing various options that customers want—and more choices—invoices will get paid faster.
4. Choose the Right Invoicing Terms
According to research conducted by FreshBooks, word choice also affects how quickly customers pay.
First, politeness matters, with the use of “please” and “thank you” increasing the percentage of invoices paid on time. Second, specifying exact payment days (e.g., 30) will also get your clients to pay you quicker.
Finally, asking for payment sooner also gets you paid sooner. For instance, for invoices sent with the payment terms “30 days,” 40.22% got paid within 7 days and 27.56% in 30+ days. In contrast, invoices sent with the terms “7 days,” 58.05% got paid in fewer than 7 days and 16.51% in 30+ days.
A Final Word on Late Payment Fees
We all want to get paid on time because cash flow is important. But the reality is that this doesn’t always happen.
While charging a late payment fee is one way to handle these late payments, as it incentivizes clients to settle unpaid invoices, it’s not always the best idea. Treat each late payment on a case-by-case basis, providing a grace period and choosing payment plans and payment extensions where a softer touch is warranted.
And where late payments are becoming increasingly more regular, it may be time to revise your late payment policies to get paid faster in the first place. Because let’s face it, prevention is often better than the cure.
This post was updated in December 2022.