1) What a “penalty clause” in a loan really is

In Philippine civil law, a penalty clause is a stipulation that imposes a fixed sum or a determinable amount to be paid if the borrower (debtor) fails to comply with the loan obligation—typically, if the borrower defaults or delays payment. The Civil Code calls this a “penal clause.” (Civil Code, Arts. 1226–1230)

A penalty clause is closely related to—but not the same as—interest:

Interest is the price for the use of money (compensatory in character).
Penalty is generally liquidated damages for breach or delay (punitive/coercive in character), meant to secure performance and pre-estimate damages.

In real-world loan contracts, penalties are often phrased as:

“Penalty charge of 1% per day on the unpaid amount until fully paid,” or
“3% per month penalty in addition to interest,” or
“Liquidated damages equivalent to X% of the outstanding balance per day/month.”

Daily penalties are the most legally risky because they explode mathematically—and courts react strongly when the resulting charge becomes shocking, confiscatory, or oppressive.

2) The legal foundation: why penalties are allowed—but policed

A. Freedom to contract is not absolute

Philippine law recognizes contractual freedom, but it is limited by law, morals, good customs, public order, and public policy. (Civil Code, Art. 1306)

Penalty clauses are valid in principle because parties may stipulate terms—but only to the extent those terms remain lawful and not contrary to public policy.

B. The Civil Code rules on penal clauses (the core doctrine)

1) Penalty substitutes damages and interest, unless parties stipulate otherwise As a default rule, the penalty generally takes the place of damages and interest for breach, unless the parties clearly agree that penalty is on top of damages or interest. (Civil Code, Art. 1226)

2) Courts may reduce penalties in two key situations (the “equitable reduction” power) The Civil Code expressly empowers courts to reduce penalties:

If there has been partial or irregular performance (e.g., borrower paid some installments, made partial payments, or substantially complied), the penalty may be reduced. (Civil Code, Art. 1229)
If the penalty is iniquitous or unconscionable, even without partial performance, courts may reduce it. (Civil Code, Art. 1229)

This “unconscionability reduction” is the central tool used against abusive daily penalties.

3) Nullity of the penalty does not necessarily void the principal obligation Even if a penalty provision is struck down or reduced, the loan itself typically remains enforceable, because the penalty is an accessory stipulation. (Civil Code framework on accessory obligations; see also the general approach in obligations/contract law.)

3) How “daily penalties” become legally problematic

A. The compounding effect: why “per day” triggers judicial alarm

A “1% per day” penalty looks simple, but it translates roughly to:

~30% per month (on a 30-day month),
~365% per year (if applied daily for a year), often on top of contractual interest and other charges.

Even at lower daily rates (e.g., 0.5% per day), the annualized burden can still be enormous.

Courts evaluate substance over form: if a daily penalty functions like disguised interest or results in a confiscatory charge, it becomes vulnerable.

B. What makes it “unconscionable” in Philippine jurisprudence

Philippine courts have repeatedly held that unconscionable interest rates and penalty charges are subject to equitable reduction. This line of cases arose especially after the suspension of usury ceilings (more below). The standard language in decisions is that courts will strike down or reduce stipulations that are “iniquitous,” “unconscionable,” “excessive,” or “shocking to the conscience.”

A daily penalty becomes legally toxic when it:

bears no reasonable relation to actual or probable damages, and/or
operates as a punitive confiscation, and/or
takes undue advantage of a borrower’s vulnerable situation, and/or
is grossly disproportionate to the principal obligation and the risk.

C. Penalty + interest stacking: the common abusive pattern

A frequent structure in loan contracts is:

High interest (e.g., 3%–6% monthly), plus
Penalty (e.g., 3% monthly or 1% daily), plus
Attorney’s fees (e.g., 10%–25%), plus
Other charges (“service fee,” “handling fee,” “collection fee”).

Courts may reduce one or more of these when the total package becomes oppressive. A penalty that is “reasonable” in isolation can still be reduced if it becomes excessive in combination with interest and fees.

4) The post-usury landscape: why “no usury ceiling” does not mean “anything goes”

A. The Usury Law and the BSP circulars (practical effect)

The Philippines historically had statutory ceilings under the Usury Law. Later, interest-rate ceilings were effectively lifted/suspended through Central Bank/BSP issuances (commonly associated with the policy shift that allowed parties to stipulate rates).

Key point: Even after ceilings were lifted, the Supreme Court maintained that courts may still intervene when stipulated rates or charges are unconscionable.

So, lenders often argue: “Usury is legally dead.” Borrowers respond: “Even if there’s no ceiling, courts can reduce unconscionable rates.” The borrower’s position has strong doctrinal support in civil law and jurisprudence.

B. Do courts “void” unconscionable penalties or “reduce” them?

Typically, courts reduce rather than completely nullify—using:

Civil Code Art. 1229 (for penalties), and
Civil Code Art. 2227 (liquidated damages may be equitably reduced if iniquitous or unconscionable).

Penalty clauses are essentially a form of liquidated damages, so courts often invoke both concepts in reasoning.

5) The legal mechanisms courts use to strike down or cut daily penalties

A. Civil Code Article 1229 (the direct weapon)

Courts may reduce penalties if:

Partial/irregular performance; or
Penalty is iniquitous/unconscionable.

This applies even if the borrower technically breached.

B. Civil Code Article 2227 (liquidated damages reduction)

Liquidated damages may be reduced if they are iniquitous/unconscionable.

C. Abuse of rights and good faith principles

Even when a contract clause exists, its enforcement may be limited by:

Art. 19 (act with justice, give everyone his due, observe honesty and good faith),
Art. 20 (liability for willful or negligent acts contrary to law),
Art. 21 (liability for acts contrary to morals, good customs, or public policy).

These provisions are often used to frame oppressive penalties as a form of bad-faith extraction.

D. Public policy control through Art. 1306

Contractual freedom yields when a term becomes contrary to public policy—especially when it resembles economic coercion rather than fair compensation.

6) What courts look at when deciding if a daily penalty is unconscionable

Philippine courts generally do not use a single numerical threshold; they apply equity and context, including:

Rate structure

Is the penalty per day and effectively astronomical when annualized?
Is it on top of already-high interest?
Is it applied to principal only or to total outstanding including interest and charges?

Total effective burden Courts look at what the borrower actually ends up owing. If the penalties balloon the obligation far beyond the principal in a short period, that’s a red flag.
Length of default Daily penalties that run indefinitely can create “never-ending debt.” The longer the period, the more likely judicial reduction becomes.
Borrower circumstances and bargaining power Was it a take-it-or-leave-it loan? Was the borrower in distress? Was there meaningful negotiation?
Nature of creditor Banks and regulated financial institutions may be judged with reference to reasonableness and industry practice; private lenders and informal arrangements often draw closer scrutiny where terms are extreme.
Security and risk If the loan is well-secured (e.g., real estate mortgage), a crushing penalty is harder to justify as “risk pricing.”
Partial payments / substantial compliance Any partial payment can trigger equitable reduction more readily because Art. 1229 explicitly mentions partial/irregular performance.
Bad faith collection behavior Harassment, threats, or oppressive collection tactics can influence how a court views the fairness of enforcing the penalty.

7) Common judicial outcomes: how penalties get “fixed” by courts

When a penalty is found unconscionable, courts commonly do one or more of the following:

A. Reduce the penalty to a reasonable monthly or annual rate

Courts often bring penalty charges down to more moderate levels, sometimes aligning them with commonly accepted figures in case law patterns (frequently discussed in terms of per annum or per month reasonableness).

B. Reduce both interest and penalty

If the interest is already unconscionable (e.g., very high monthly interest) and the penalty is also high, courts may reduce both.

C. Disallow compounding/stacking effects

Courts may:

Treat “penalty” as part of interest if it functions as such,
Disallow penalties computed on top of already-accrued interest in ways that create runaway compounding,
Limit penalties to principal or to a fixed base amount.

D. Limit attorney’s fees

Even if attorney’s fees are stipulated (e.g., 25%), courts often reduce them when unconscionable or not supported by evidence of actual legal work and reasonableness, because attorney’s fees are not awarded as a matter of right.

8) Practical illustrations: how daily penalties can become legally indefensible

Example 1: 1% per day penalty on ₱100,000 unpaid principal

Day 1 penalty: ₱1,000
30 days: ₱30,000 (30% of principal)
90 days: ₱90,000 (almost the entire principal again)

If this is in addition to interest (say 3% per month), the effective burden can rapidly exceed what courts view as equitable compensation.

Example 2: “Penalty computed on outstanding balance including interest”

If the contract defines “outstanding balance” to include accrued interest and fees, then the penalty is effectively a penalty-on-interest, which can magnify the unconscionable effect.

Courts are more likely to intervene when the base is broadened this way.

9) The line between “penalty,” “liquidated damages,” and “interest” (and why labels don’t save a bad clause)

Courts look at economic reality:

A “penalty” that is triggered by delay is usually liquidated damages.
A “service fee” that functions as a charge for the use of money may be treated like interest.
A “collection fee” that automatically accrues daily may be treated like a penalty.

Renaming a daily penalty as “administrative cost” does not immunize it if it operates like a punitive interest substitute.

10) When daily penalties can be considered illegal (not merely “high”)

A daily penalty provision becomes legally vulnerable to being reduced, disregarded, or struck down when:

It is iniquitous or unconscionable under Art. 1229 / Art. 2227;
It violates public policy under Art. 1306;
It is enforced in a manner that constitutes abuse of rights (Arts. 19–21);
It effectively results in oppression or unjust enrichment, especially when the lender’s actual risk and probable damages do not justify the charge.

In many decisions, the practical effect is not that the borrower pays nothing—rather, the court recomputes the obligation using reduced rates.

11) Litigation and enforcement contexts where this issue commonly appears

A. Collection suits / sum of money cases

Borrowers raise unconscionability as a defense and ask for judicial reduction.

B. Foreclosure (real estate or chattel mortgage)

Even when a creditor forecloses, disputes over deficiency and computation often bring penalty clauses under scrutiny.

C. Small claims

Even in small claims settings, courts can refuse to enforce facially abusive charges and may compute amounts based on what is legally recoverable.

D. Corporate loans vs. consumer/personal loans

Corporate borrowers are sometimes presumed to have more bargaining power, but unconscionability can still apply if the clause is extreme.

12) Drafting realities: what penalty clauses tend to survive scrutiny

Penalty provisions are more defensible when they are:

Moderate (not daily compounding at extreme effective rates),
Clearly defined (base amount, trigger, and duration are unambiguous),
Proportionate to the likely damages from delay and collection costs,
Not stacked oppressively on top of already-high interest,
Capped (e.g., penalty up to a maximum percentage of principal or for a maximum duration),
Structured to avoid “penalty-on-penalty” or “penalty-on-interest” escalation.

Clauses that say “1% per day until fully paid” with no cap are among the most vulnerable.

13) Key Civil Code provisions to know (quick reference)

Art. 1226 – Penal clause; substitutes damages/interest unless otherwise stated.
Art. 1229 – Court may equitably reduce penalty for partial/irregular performance or if unconscionable.
Art. 1230 – Penalty demandable without proving actual damages, subject to reduction rules.
Art. 1306 – Freedom to contract limited by law, morals, good customs, public order, public policy.
Art. 2227 – Liquidated damages may be reduced if iniquitous or unconscionable.
Arts. 19–21 – Good faith/abuse of rights/public policy-based liability principles.

14) Bottom line: the Philippine rule on daily penalties in one sentence

Daily penalties in loan contracts are not automatically void, but they become legally unenforceable to the extent they are iniquitous or unconscionable, and Philippine courts have explicit authority to reduce them to equitable levels—especially when “per day” charges create a crushing, runaway debt that shocks the conscience and offends public policy.