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Are Late Payment Penalties a Good Idea in Construction?

Are Late Payment Penalties a Good Idea in Construction?

May 25, 2021

Late payments are one of the most common problems in the construction industry. It doesn’t matter how diligent you are in completing your tasks or how efficient you are in sending out your invoices – there will always be clients who will struggle to pay on time.

One way to curb the problem of late payments is to charge late payment fees. If a client pays late, they will need to pay extra as a penalty for not paying on time. This can encourage your clients to pay on or before the due date and to avoid missing the payment deadlines.

Why are late payments common in construction?

  1. Payment delays cause a domino of late payments throughout the contracting chain.

    The construction industry follows a hierarchical payment structure. Payments flow from top to bottom throughout the contracting chain, and these payments are interlinked. If a top-tier contractor does not get paid on time, the subcontractors and material suppliers working under them will also not receive their payments on time.

    This hierarchical structure is one of the biggest reasons why late payments happen to almost all construction participants. Whether you are a prime contractor, subcontractor, designer, or material supplier, you need to bear in mind that no project stakeholder is immune to late payments.

  2. Construction companies do things differently.

    Another reason why payment issues are common in construction is the lack of universal practices across all construction projects. The absence of standardized methods and systems only increases the risk of miscommunication and other disputes.

    Say, for example, that a material supplier issues a paper invoice to a client who prefers electronic billing. The paper invoice may get lost in the mix because the two parties do not share the same invoice management practices. This scenario is likely to result in late or disputed payments.

  3. Project costs and scopes are often disputed.

    Payment disputes are also one of the biggest reasons behind construction’s late payment problem. Construction parties often argue about the amounts that need to be paid, so payments get delayed until the disputes are sorted out.

    For example, a contractor and a property owner may not agree on changes in project scope. A contractor may insist that they need to get paid more for doing extra work, but a property may argue that the contractor did not do anything more than what they were contractually obligated to do. Unless both parties agree on the payment terms right away, the contractor is not likely to get paid by the due date.

Is charging late payment penalties a good solution?

There are many ways to protect your business from late payments, and one of them is to charge late payment fees. So, yes, charging late payment penalties can be a good idea if you’re running a construction business. Doing so encourages your clients to pay on or before the due date. It also imposes a consequence against your clients if they fail to honor their payment obligations on time, which lets them know that you take late payments seriously.

Note, however, that late payment fees are not a catch-all solution against late payments. It could reduce late payments, but it will not necessarily prevent your clients from ever paying late again.

There are advantages to charging late payments, but there are disadvantages that you should consider.

Advantages and Dis

Advantages of charging late payment fees

  • Encourages clients to pay on time 

    When you charge a late payment fee, you give your clients a reason to pay on time. You encourage them to do everything they can to send the money on or before the due date because, otherwise, they will need to spend more and pay the required penalties.

  • Helps ensure that you have cash on hand 

    Working with clients who pay on time will put you in better financial shape. If your clients pay on the day you expect them to pay, you will have a steady cash flow, and you will have access to your cash right away if and when you need it.

Disadvantages of charging late payment fees

  • May discourage some clients 

    Charging late payment penalties may discourage and alienate some of your clients, especially those who are struggling financially. When imposing late payment penalties, understand how to strike a balance between imposing the rules and keeping your most loyal clients.

  • May be costly when managing disputed fees 

    Late payment fees can be a fixed rate or a certain percentage of the overdue payment. If you are dealing with large volumes of late payment charges and some of those charges are being disputed, it may cost you some time and resources to manage your books.

How should you manage late payments?

  1. Be open to negotiation

    Because late payments happen so frequently in construction, you should always be prepared with a course of action once your clients fail to pay on time. You do not always have to penalize them. Sometimes, you can have a better chance at keeping your best clients if you are open to negotiating the terms if they ever pay late.

  2. Implement a late payment policy

    Having a robust policy for dealing with late payments will help you manage late payments efficiently. If you have a standard set of rules for what to do when clients pay late, you will save a lot of time in trying to figure out what to say, when to call, or when to reach out to third-party collectors.

  3. Consider charging late payment fees

    Asking your clients to pay more if they do not pay on time is one way to encourage them against paying late. While charging late payments will not completely stop your clients from being delinquents, it can steer them the right way and push them to pay up on or before the due date.

Contractor payment terms and late payment fees: what’s the difference?

Payment Terms vs Late Payment Fees

Construction companies are encouraged to include late payment fees as part of their payment terms.

Payment terms are the rules and conditions that govern how the payments will be exchanged between you and the client. These rules include the amount that you expect to receive, the deadlines for making the payments, the possible payment methods, and even the consequences for not issuing the payments on time.

If you want to impose late payment fees on your clients, your payment terms must include a clause saying that late payment fees will apply. It is not a good idea to charge your clients late payment fees without informing them first. Hiding the fact that you will be charging late payment fees can only alienate your clients.

It is also important to note that charging late payment fees is best seen as a preventative measure, not as a means to earn more money. You want to include the late fees in your payment terms so your clients are aware that they can be charged extra if they miss the payment deadlines.

How much do you charge for late payments in construction?

There is no fixed standard for how much you should charge as late payment penalties in construction. Every company works differently, and you can make your call depending on what you believe is best.

However, before deciding your late payment rates, you should consider the following:

  • Late payment fees should not be an additional source of revenue.

    Do not make the mistake of charging extremely high late payment fees, thinking that you can earn more if by penalizing your clients. Charging late payment fees is a way to encourage your clients to pay on time, not to increase your revenue.

  • There are state-specific laws about how much interest you can charge.

    You should be familiar with the usury laws in your state that cap the amount of interest that you can charge on a client. You can calculate your late payment fees by dividing the maximum interest rate by 12 months. For example, if your state imposes a maximum of 15% interest on loans, you can charge interest of 15%/12 = 1.25%.

    The late payment fee will then be 1.25% of the outstanding amount.

When should you charge late payment fees?

Now that you have an idea of how much to charge your clients, you may be wondering when you should start imposing late payment fees. Do you ask for a 1.25% interest a day after the missed payment deadline? Do you wait a month, two months, or three months?

It is up to you how you want to structure your payment terms and when the late payment fees will kick in. Some companies charge between 1% to 1.5% interest 30 days after the payment deadline. Others do not start an interest until after 60 days have passed.

The key is to find what works best for you, considering the types of clients that you have. This is why having a trade credit policy and a late payment policy is important. You want to standardize your practices, so you can continuously improve them until you find what works best.

Alternatives to charging late payment fees

Charging late payment fees is not the only way to manage late payments in construction. You can also consider the following alternatives or solutions:

  • Offer a payment plan

    If a client misses a payment deadline, you can give them a call and negotiate a payment plan. A payment plan can allow your client to pay in smaller amounts over a longer period of time. This can be helpful for clients who may not have the full amount at the moment but are promising to pay over the next few months.

  • Offer on-time payment discounts

    Instead of penalizing your clients for paying late, you can also offer them incentives for paying on time. On-time discounts sound better from a marketing perspective. You are penalizing negative behavior but are instead giving rewards to those who do a good job in paying on or before the payment deadline.

  • Offer a payment deadline extension for first-time offenders

    Even your best clients can suffer temporary cash flow setbacks. Extending the payment deadlines for clients who miss the deadline for the first time can be a good way, especially if you want to keep working with them in the future.

How to manage unpaid invoices

  1. Automate payment reminders

    Missed payments can happen due to all sorts of reasons. Clients can forget that a payment is due, so it is best if you can automate your payment reminders or make it part of your policy to remind your clients of upcoming payment deadlines. You can also remind them if a payment was missed, just so they know that you are expecting to receive payment.

  2. Make effective payment collection calls

    Calling your clients and asking for payment must be done with a plan in mind. You want to prepare for the call and make sure that you know all the details about their invoices and that you are prepared to answer their questions. Be ready to take notes. If you do your collection calls properly, you are in better shape to get your clients to pay up.

  3. Offer flexible payment options

    Having limited payment methods can be restrictive for your clients. For example, if you only accept cash or cheque payments, some clients may struggle to pay on time because they do not issue cash or cheque as part of their business practices. You should allow for more payment methods so you can accommodate the needs of your clients.

Best practices against late payments

  1. Serve preliminary notices at the beginning of each project

    Serving preliminary notices can do wonders in encouraging your clients to pay on time. When you serve a preliminary notice, you open the communication lines between you and the property owners and/or general contractors. You become more “visible” to them, and this becomes important, especially in large-scale projects when owners can lose track of who to pay.

    Serving a preliminary notice at the beginning of a project also protects your lien rights. In most states, you cannot file a mechanics lien unless you have served the appropriate preliminary notices properly. If you want to preserve your right to file a lien, you should make it part of your standard operating procedures to serve a valid preliminary notice in every project that you work in.

  2. Ensure invoices are served on time

    Late payments are not always the fault of the clients. Sometimes, late payments can happen because the clients did not receive the invoices on time. If you do not send out your invoices on time, your clients will not know how much they owe you. If they do not know the amount that they need to pay, they will not be able to process the payments in time for the deadlines.

    Being efficient with how you manage your invoices is, therefore, one of the ways to prevent late payments from happening. If you send out your invoices on time, and if your invoices are always accurate, your clients will have no excuse not to pay you on or before the due date.

  3. Be specific in your contracts

    Payment disputes are one of the most common causes of payment delays. When you and your clients do not agree on the cost of the services, nobody will get paid until the dispute is settled. The best way to settle disputes is to refer back to the contract and determine what has been originally agreed upon by both parties. It is, therefore, extremely important that your contract is robust and specific.

    A robust contract has a clear project scope. It specifically assigns which parties are responsible for which tasks. Liabilities and payment terms must also be specific. Ambiguous provisions will only result in further disagreements, and they will not help at all in settling payment disputes.

  4. Serve a Notice of Intent to Lien

    A notice of intent to lien is not the same as a preliminary notice. A notice of intent to lien is a document that is served when payment has been missed and when it is proving difficult to recover payment from a client. Since nobody wants to deal with a mechanics lien, serving a notice of intent to lien can encourage your clients to pay up.

    Note that a mechanics lien is still one of the most effective weapons against delinquent clients. When a client consistently pays late, you can serve them a notice of intent to lien, so they are aware that you are willing to file a mechanics lien if your invoices remain unpaid.

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