A comprehensive legal guide for borrowers, lenders, and counsel

1) Why this topic matters

“Short-term” loans (payday, salary, 30–180-day personal or business credit, appliance/phone installments, quick-cash from lending apps, and post-dated-check arrangements) often quote 40% interest—sometimes as a flat/add-on rate, sometimes as a one-time “processing/finance charge,” and sometimes embedded in penalties. Whether that is lawful, void, or reducible depends on (a) how the rate is computed and disclosed, (b) who the lender is (bank vs lending/financing company vs private individual), (c) the contract text, and (d) Philippine civil-law doctrines against unconscionable stipulations.

This article puts everything in one place: the legal framework, how courts analyze “40%,” risk points for each side, and practical playbooks.

2) The legal framework at a glance

A. Usury ceilings repealed in effect, but courts still police unconscionability

The old Usury Law (Act No. 2655) set ceilings, but these ceilings were lifted by Central Bank/BSP policy decades ago.
There is no fixed statutory maximum interest rate for most private loans today.
However: Courts routinely strike down or reduce interest/penalty rates that are “iniquitous” or “unconscionable,” even though no numerical cap exists. This is grounded in the Civil Code (Arts. 1306 [freedom of contract limited by law/morals], 1229 and 2227 [reduction of penalty/liquidated damages if iniquitous], 19–21 [abuse of rights/morals], and 24 [equity]).

Practical consequence: A stipulated 40% can be enforceable or judicially reduced to a reasonable level, depending on context.

B. Special caps and sector rules

Some credit products (e.g., credit cards) have regulatory caps set by the Bangko Sentral ng Pilipinas (BSP). By contrast, non-bank lending/financing companies are primarily governed by contract, the Lending Company Regulation Act (RA 9474), the Financing Company Act (RA 8556), and SEC conduct rules—not a hard number ceiling on interest—but still subject to unconscionability review and consumer-protection norms.

C. Truth in Lending Act (RA 3765) and disclosure

Lenders must disclose the finance charge and the effective cost of credit (not just a nominal rate). Non-compliance exposes them to civil liability and undermines the enforceability of charges that were not clearly and properly disclosed.

D. Form requirements on interest

Under Civil Code Art. 1956, interest is not due unless expressly stipulated in writing. If the written contract omits an interest clause, no contractual interest may be charged—though legal interest may apply on amounts due after default.

E. Legal interest rates (for re-computation)

When courts reduce or nullify an unconscionable rate, they commonly apply legal interest (jurisprudentially set and periodically adjusted by BSP circulars) at simple interest, either 6% per annum or as updated by case law/circulars for (i) loans/forbearance prior to judgment and (ii) judgment obligations.

3) What “40%” could mean—and why wording matters

1) 40% per annum (p.a.) nominal

If properly disclosed and not a product under a special cap, courts may uphold it unless circumstances show unconscionability (e.g., huge imbalance, vulnerable borrower, predatory pressure, or stacked fees).

2) 40% flat/add-on on a short tenor

A “flat” or “add-on” rate applied to the original principal—not the declining balance—inflates the effective interest rate (EIR).
Example: ₱10,000 borrowed for 3 months at 40% flat for the term means ₱4,000 “interest” on top of ₱10,000, repaid in three equal installments. The EIR is far higher than 40% p.a. because you are paying interest as if the full ₱10,000 remained outstanding the entire time.

3) 40% as a one-time “processing/handling” fee

Courts look at substance over label: if a fee functions as interest (i.e., the price of credit), it may be treated as interest for unconscionability analysis.

**4) 40% as penalty or late charge

Even when principal interest is moderate, stacked penalties (e.g., 5% per month penalty plus compounding) are frequently reduced under Arts. 1229/2227.

Key takeaway: The effective cost of credit (EIR) is determinative, not the label.

4) The jurisprudential test: When is 40% “unconscionable”?

While the Supreme Court has not set a hard ceiling, it has invalidated or reduced interest/penalty rates—especially where monthly rates compound, or penalties pile on, or the borrower is captive (e.g., salary loans with employer control), or disclosures are opaque. Factors include:

Nature of the lender (institutional sophistication vs. individual).
Disclosure quality (was the EIR clear? were fees rolled into “interest”?).
Bargaining parity (adhesion contract? financial distress?).
Tenor and compounding (short-term add-on rates can skyrocket EIR).
Overall equities (conduct, harassment, good faith, partial payments).

Trends to note:

Monthly rates > 3%–5% with add-on mechanics, ballooning penalties, or compounding, draw heightened judicial skepticism.
Courts often strike penalty interest or cut it to a reasonable level, then apply legal interest from default or judgment.

5) Lender category matters

Banks/BSP-supervised entities: Must follow BSP disclosure and consumer-protection standards; some products carry explicit caps.
Financing/lending companies (SEC-supervised): No universal fixed ceiling; still bound by RA 3765, RA 8556/RA 9474, SEC rules on unfair collection and transparent pricing, and the Civil Code against unconscionable stipulations.
Private individuals/peer loans: Fully subject to Art. 1956 (written stipulation required), Truth in Lending if acting as a lender in fact, and unconscionability limits.

6) Computation clinic: turning “40%” into EIR

Scenario A: 40% per annum on a 90-day loan, simple interest

Principal: ₱50,000; Annual rate: 40%; Term: 90/365 of a year
Simple interest = 50,000 × 0.40 × (90/365) ≈ ₱4,932.
If amortized properly on a declining balance, the EIR ≈ 40% p.a.; if add-on on original principal, the EIR is higher.

Scenario B: “40% flat” for 3 months

Fee/interest = 50,000 × 40% = ₱20,000 over 3 months.
Paying ₱70,000 in three equal installments implies an astronomical EIR (multiples of 40% p.a.) because you repay principal early but still pay full “interest.”

Red flags: “processing fee,” “service charge,” “doc stamps,” “insurance” deducted upfront reducing net proceeds, which inflates the true EIR. Courts may treat undisclosed/rolled-in amounts as part of the finance charge.

7) Enforceability map: when 40% survives and when it doesn’t

Likely enforceable (case-by-case):

Clear written stipulation (Art. 1956), transparent RA 3765 disclosure, declining-balance computation, no compounding or modest penalty, commercial context with bargaining parity, and no special cap applies.

At risk of reduction/nullity:

Add-on/flat 40% over a short term producing outsized EIR;
Penalty interest ≥ 3% per month or cascading penalties;
Compounding without express basis;
Opaquely disclosed fees functioning as interest;
Harassing collection or privacy violations (affects damages and equity);
Contracts of adhesion with vulnerable borrowers.

When courts intervene, they typically (i) void the unconscionable rate, (ii) substitute legal interest from the date of default or judicial demand, and (iii) may award moral/exemplary damages and attorney’s fees if lender conduct was in bad faith.

8) Civil Code tools you will actually cite

Art. 1956: No interest unless expressly stipulated in writing.
Art. 1306: Freedom of contract limited by law, morals, good customs, public order, public policy.
Art. 1229: Courts may reduce a penal clause if iniquitous or unconscionable.
Art. 2227: Liquidated damages may be equitably reduced if iniquitous or unconscionable.
Arts. 19–21: Abuse of rights and acts contrary to morals/good customs—basis for damages.
RA 3765 (Truth in Lending): Requires disclosure of finance charge and effective cost; non-compliance supports civil liability.

9) Compliance and risk checklist for lenders

Put the interest clause in writing and obtain the borrower’s signature/OTP acceptance.
Disclose the EIR and all charges (processing, facilitation, insurance, delivery, notarial).
Use declining-balance amortization; avoid “flat” add-on for very short terms or, if used, prominently disclose the EIR.
Keep penalty rates reasonable; avoid compounding unless clearly stipulated and defensible.
No hidden offsets: If fees are deducted upfront, treat them in the EIR.
Fair collection only; no public shaming; follow privacy and consumer-protection rules.
Maintain audit trails of disclosures and consents.

10) Defense and remedies menu for borrowers

A. Contract & statutory defenses

No written interest stipulation (Art. 1956) → contractual interest void; only legal interest may apply from default.
Unconscionable interest/penalty → seek judicial reduction under Arts. 1229/2227, with re-computation at legal interest.
Truth in Lending violations (RA 3765) → claim damages for non-disclosure or misleading disclosure; argue that disguised fees are part of the finance charge.
Invalid compounding → if compounding wasn’t expressly and clearly stipulated, courts tend to disallow it.

B. Negotiation & restructuring

Propose rate haircut, waiver of penalties, tenor extension, and interest-only periods.
Offer lump-sum settlement with partial condonation of interest/penalties.
Seek debt review: a written amortization schedule showing declining balance and EIR.

C. Litigation posture (if sued or suing)

Answer with affirmative defenses: lack of written stipulation, unconscionability, wrong computations, TILA breaches.
Move for re-computation attaching your amortization/EIR analysis (expert report helps).
Pray for: voiding/reduction of interest & penalties, legal interest only, and damages/attorney’s fees for bad-faith conduct.
Small Claims (for lower amounts): raise unconscionability and disclosure defects; bring clear computations and documentary proof.

D. Regulatory & privacy recourse (if applicable)

File complaints with SEC (lending/financing companies) or BSP (banks) for unfair practices.
If your contacts were messaged or your data was exposed, consider a Data Privacy complaint.

11) How to review a 40% short-term loan contract (step-by-step)

Identify the base: Is 40% per annum, per term, per month, or flat?
Unpack all charges: processing, insurance, delivery, notarial, collection, app fees.
Compute EIR: Convert add-on and upfront deductions to an annualized effective rate.
Check penalty mechanics: rate? basis? per month or per day? compounding? cap?
Verify disclosure artifacts: RA 3765 compliance sheet, amortization schedule, total finance charge.
Look for compounding language: If absent or vague, assume simple interest.
Assess equities: Was there pressure, misrepresentation, or adhesion? Any harassment?
Map your remedies: Negotiate; if not, litigate for re-computation and damages.

12) Worked examples

Example 1: 40% p.a., 120-day loan, declining balance, no penalties

Likely defensible if properly disclosed; borrower may still challenge reasonableness depending on context, but courts often uphold commercial rates that are transparent and non-punitive.

Example 2: “40% flat” on a 60-day loan + 5%/month penalty

High risk of being reduced. The flat method over short tenor inflates EIR; penalty of 5%/month may be iniquitous—ripe for Art. 1229/2227 reduction and legal interest substitution.

Example 3: 40% “processing fee” deducted upfront; contract says interest is 0%

Courts may re-characterize the fee as interest, trigger RA 3765 non-disclosure consequences, and re-compute at legal interest only.

13) Evidence you’ll need (both sides)

Signed contract and any electronic acceptance.
Disclosure statement and amortization schedule (if any).
Proof of disbursement and net proceeds (bank transfer slips, receipts).
Payment history and ledger showing computations and any compounding.
Communications (texts, emails, app logs) on rates/fees/collection.
Expert/CPA computation of EIR and legal-interest re-computation.

14) Drafting & negotiation templates (essentials)

Borrower proposal (core elements):

Acknowledge debt; dispute unconscionable interest/penalties and RA 3765 defects.
Offer lump-sum or restructured plan at reasonable interest (e.g., legal interest) and waiver of penalties.
Request updated amortization on a declining balance, no compounding.

Lender counter (core elements):

Provide full RA 3765 disclosures and a clear amortization table.
Offer penalty cap and interest haircut in exchange for earlier payment.
Include no-harassment and data-privacy covenants to avoid collateral disputes.

15) FAQ

Is 40% automatically illegal? No. There is no universal ceiling. But a court may reduce or void it if unconscionable, poorly disclosed, or made punitive by add-ons/penalties/compounding.

If the contract says “40% per term,” what then? Compute the EIR. If the term is short (e.g., 1–3 months), the annualized cost may be extreme, increasing the chance of judicial reduction.

What if interest isn’t in writing? Contractual interest is not due (Art. 1956). Only legal interest may run from default or judicial demand.

Can penalties be higher than interest? They can be stipulated, but courts often cut penalties that exceed or duplicate interest, or that compound, as iniquitous.

16) Strategic takeaways

For borrowers: attack methodology (flat/add-on), disclosure (RA 3765), penalties, and compounding; push for legal-interest re-computation.
For lenders: win on transparency—clear EIR, declining-balance math, reasonable penalties, and clean collection conduct.
For both: settle early with a re-computation everyone can live with; litigation often ends in a court-imposed legal-interest solution plus cost/delay.

This article is for educational purposes and is not a substitute for tailored legal advice. Specific facts, updated regulations, and recent jurisprudence can materially change outcomes; consult Philippine counsel for your case.