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In Finance, what is a Penalty Clause?

Mary McMahon
Updated Jan 27, 2024
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A penalty clause is a clause in a contract which mandates financial forfeiture in the event that one party breaches the contract. Penalty clauses are specifically designed to penalize, going above basic compensation for losses which might occur as a result of breach of contract. People may refer to the funds mandated in the penalty clause as “penal damages,” distinguishing them from other types of damages which can also be written into legal contracts.

If a caveat in a contract is clearly a penalty cause, it may not be enforceable in court. The court will not mandate someone to pay a penalty which is unrelated to the specifics of the contract, or which is deemed excessive. “Excessive” can be defined by standard practice with similar contracts, and by the specifics of the situation. A lawyer who has experience with contract law can review the terms of a contract to determine whether or not they are reasonable, and provide advice about rewriting or reformulating to make the terms fair. A lawyer can also provide advice on inserting a penalty clause if the parties to the contract feel that it is necessary.

This contrasts with damages such as liquidated damages, which are intended as compensation in the event that there is a breach of contract. For example, someone writing a contract to sell a house can write in liquidated damages, with the buyer forfeiting some funds in the event that the contract is broken, while the seller may be forced to compensate with payments of rent or similar damages in the event that they back out of the contract. This is intended to create a mechanism for recovering compensation after the contract is breached.

When writing up and looking at a contract agreement, it is important to fully understand the terms, and to question anything which seems odd or unfamiliar. While a penalty clause may not be enforceable in court, people may not be ready or willing to take it to court, and they should consider whether or not they are willing to pay the stated penalty if they decide to cancel the contract.

The idea behind inserting liquidated damages and other types of clauses into contracts is to make sure that there is a clear consequence for breaking the contract, so that people understand the seriousness of the agreement they are making. These stipulations are also designed to make sure that people are more likely to fulfill the contract. A penalty clause takes this one step further, creating potential punishment as a consequence for a breach.

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Mary McMahon
By Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a WiseGeek researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

Discussion Comments
By honeybees — On Jun 01, 2012

I am the type of person who likes to pay off a contract faster than what the original length of the terms are.

For this reason, one thing I always look for is some kind of prepayment clause. With some contracts, there is actually a penalty if you pay it off early.

If there is ever a penalty for this, I will never sign the contract. I understand the advantage of this is that they get all the interest for the entire life of the contract.

If I want to pay something off early and save some money in interest, I want to know there is not going to be a penalty for it.

By julies — On May 31, 2012

@sunshined - This happened to a co-worker of mine. She doesn't speak the best English, and someone sold her a water unit for her home.

She felt like she could afford the monthly payments of the contract and wanted to provide better water for her family.

She started having some financial problems and was not able to make the payments on this contract. I don't know if there was a penalty clause in her contract, but they have been very aggressive at collecting her payments.

Now her wages are being garnished until she gets this paid off. So not only is she responsible for making the original payments, but also extra in the amount of late fees and fines.

This is just one reason why it is so important to understand what you are signing any time you sign a contract.

By sunshined — On May 30, 2012

Whenever I am signing any kind of contract, I always make sure to take my time and read it over carefully. Paying attention to the fine print is also important.

I think many people feel like they don't really understand all of the terms, and just quickly go through and sign their name where they are supposed to.

Most of the time, the party that breaches the contract is the person who is making the payments. This is when the penalty clause is really not in their favor, and they might not even realize it is there if they didn't understand the terms of the contract.

Many times they really don't understand what they have signed until they run into some kind of problems making the payments.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a...

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