Under the terms of a loan, if a payment is late for any reason the borrower may owe additional amounts called late payment penalties. There are different types of late payment penalties: a flat fee, such as $25, charged without regard to the amount of the late payment or how long it is outstanding, and a percentage fee, fixed with regard to the late payment. The percentage fee continues to be accessed each month that a payment remains delinquent. Only late payment penalties qualifying as “interest” may be deductible.
If you are late in making a payment, you may be charged a penalty by the lender. Generally, penalties for delinquent payments are treated as deductible interest, which can be written off if you itemize your deductions.
Example: Your monthly mortgage payment is $1,000, which is subject to a 2% late payment penalty. Due to unexpected financial reverses, you fail to make your payment for June, July, and August. In September, you’re back on your feet and pay up all outstanding amounts, including the late payment penalties of $120 (June payment: 2% of $1,000 ó 3 months; July payment: 2% of $1,000 ó 2 months; August payment: 2% of $1,000 ó 1 month). Since the late payment penalties are an interest charge, they are deductible.
Late payment penalties are treated as deductible interest as long as they are not imposed for a specific service provided by the lender. If they are a flat charge imposed regardless of how late the delinquency may be, they are viewed as a nondeductible service charge rather than as deductible interest.
Even though late payment penalties can be deductible, you should try to avoid them if possible. The deduction does not fully offset your payment. One way to do so is to arrange for mortgage payments to be debited automatically from your checking account.
Note: Being late on making your mortgage payments can cost you more than late payment penalties. Being late can adversely affect your credit rating and hurt your ability to obtain a loan or even get a job within 2 years or so of the late payment. Usually, if your payment is no more than 30 days late, it will not show up on your credit report. But anything later will be reported by the lender to the major credit reporting bureaus and can affect your creditworthiness for about 2 years.
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