When a client pays an invoice on time, it frees up your cash flow and makes tracking invoices a breeze. But what happens when a client misses a payment due date?

As a small business owner, you need to do your part when it comes to encouraging clients to meet your payment deadlines. And when combined with solid contracts and professional invoices, late fees can do just that.

What is a late payment fee?

A late payment fee is an additional amount you charge on a client’s invoice after it has passed its payment deadline. Most late fees are either a percentage of interest or a flat rate.

Many contractors and home service business owners use late payment policies to incentivize their customers to settle invoices before they’re due.

Is it legal to charge a late fee?

It’s legal to charge a late fee as long as you outline it in your contracts and invoices. Written proof will help you to ensure a customer understands your payment terms beforehand and it will also come in handy in the event of a dispute.

READ MORE: How to bill a client

Should contractors charge late payment fees? The pros and cons

Late fees come with a variety of pros and cons. Whether charging late payment fees are right for your service business or not depends on which payment issues you face and your invoicing strategy.

Pros of late charges:

1. They encourage prompt payments

Small business owners rely on prompt, predictable compensation. When clients can’t pay you on time, it has a domino effect on your finances.

Late payment fees are a consequence of paying invoices past their due dates. Because most clients won’t want to pay more for your services than they have to, late payment fees will encourage them to make payments earlier.

This allows you to benefit from a more reliable and predictable cash flow. It also keeps you from having to chase down overdue payments yourself or going through the process of selling the debt to a collection agency.

2. They help to avoid repeat late payments

Even if a client does accidentally make an overdue payment once, late fees often keep them from becoming repeat offenders. Once a customer is forced to make their first late fee payment, they’ll understand you take your late payment policy seriously and will be less likely to miss a deadline in the future.

Just make sure that you actually enforce your payment policy when necessary. If you don’t use it, your customers may take advantage of your leniency.

3. They demonstrate professionalism

Legitimate businesses come with contracts, invoices, and payment terms, including late fee policies. While customers may not be the biggest fan of late fees, they do add to your professionalism and legitimacy as a business.

Late fees demonstrate that you take your service business seriously and that you have certain expectations about your client relationships. This helps to keep clients from attempting to take advantage of you by paying invoices late or by not paying you at all.

Cons of late charges:

1. They may not make a difference

Ultimately, whether your clients pay you on time or not depends on if they’re quality customers. Unfortunately, it’s important to remember that having a late payment policy won’t turn a bad client into a good one.

If you have unreliable customers who frequently miss payment deadlines, charging a late fee probably won’t make a difference. Instead, it might be time to fire your client and to find customers who will be a benefit to your business (and your stress levels).

READ MORE: How to tactfully deal with difficult customers

2. You have to enforce late fees

Making a late payment policy and actually enforcing it are two very different things. If you decide charging late fees is right for your service business, you need to be prepared to follow through.

That means:

  • Including information about your late payment policy in contracts and on invoices
  • Figuring out how much you will charge and when
  • Communicating your policy to customers
  • Charging late fees when a payment is overdue

Enforcing late fee payments is not always a piece of cake, especially if you decide to implement a late payment policy with existing clients.

3. They may not be right for every client

Some customers don’t pay their bills on time because they don’t respect your time, while others simply don’t have the cash. Late payment policies aren’t right for every client, so that means you’ll either have to review each late payment on an individual basis or apply your policy to everyone.

That can be tough since different customers miss payments for different reasons. A customer who consistently pays on time and in full may forget due to a family emergency or banking change.

Before deciding on a late payment policy, review how often your customers miss payments and what the reasons are. If they’re few and far between, or if your only late payments are from otherwise ideal clients, there are other actions you can take.

For example, fleshing out your invoicing strategy, updating your contracts, or reevaluating your billing cycle.

How to create a late payment policy

Creating a late payment policy is relatively straightforward. Start by following these simple steps:

Step 1: Figure out the details

The first thing you need to do is figure out what exactly your payment policy will be. For example, ask yourself:

  • How much will you charge per late fee?
  • When will you charge late fees?
  • When does your policy come into effect?
  • Are there any exceptions to your late fee policy?

Step 2: Document your late payment fee policy

Next, you need to document your late fee policy in customer contracts and invoices. This means including all of the details from step one in writing.

Start by including a clause in your contracts. If you want to use a new payment policy with existing customers, have them sign a new contract or create a separate document outlining the changes.

READ MORE: Examples of payment terms on an invoice

Ideally, each invoice you send should include information about your late payment policy. This helps to ensure that clients aren’t caught off guard if they get charged a late fee for an overdue payment.

Include terms and conditions on every invoice using invoicing software to keep payment information clear and consistent.

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Step 3: Talk to your customers

Make sure to have a conversation with each of your customers about your late fee policy before an invoice is due. This will help you to avoid excuses and arguments if you do have to charge a late fee down the road.

Plus, it will encourage clients to pay you before a due date, since they know what the consequences will be if they don’t.

What is an acceptable fee to charge for a late payment?

Late fees are typically charged in one of two ways:

  • Interest rate
  • Flat rate

When using an interest rate, you would charge the client a certain interest percentage for each day the invoice is overdue. The amount you charge will vary based on the total of the invoice and the number of days it’s past due.

For example, let’s say you were going to charge 24% per year. That means you would charge a client 2% of the invoice amount for every 30 days it was passed due (24% annual interest / 12 months).

It’s important to know that the maximum interest rate you can charge per year varies in each state. Check your area’s laws before building your late payment policy.

When using a flat rate, you would charge the client a flat fee for each nonpayment within a billing cycle. For example, $15 after a payment is 30 days past due, and another $15 the next month if the invoice is still unpaid.

However you choose to charge late fees, don’t treat them as a secondary stream of income. They aren’t meant to increase your income, but to encourage timely payments and ensure your cash flow stays healthy.

READ MORE: Invoice vs receipt – what’s the difference?

How to avoid getting late payments so you don’t have to charge a fee

Late payment policies are helpful if you need to use them, but there are other ways to get paid faster and on time. Here are some recommendations to improve your payment and invoicing strategy to avoid late payments:

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