FACTS:

Petitioners Felimon and Maria Barrera borrowed P230,000.00 from spouses Miguel and Mary Lazaro, securing the loan with a real estate mortgage over their residential lot in Bulacan. The Lazaro spouses transferred the loan to respondents Emiliano and Maria Concepcion Lorenzo. Petitioners executed another real estate mortgage in favor of the respondents to secure the loan of P325,000.00. The mortgage contract stated that the loan shall be payable within three months and shall earn interest at 5% per month, with the mortgage to be foreclosed if the loan is not paid within that period. Petitioners failed to pay the loan in full on August 14, 1991, but were allowed by respondents to complete their payment until December 23, 1993, with a total payment of P687,000.00. Respondents demanded payment of P325,000.00 plus interest on January 17, 1994. Petitioners claimed that they have overpaid their obligation and demanded the return of their land title and refund of the excess payment. Respondents filed a petition for extrajudicial foreclosure of mortgage, while petitioners filed a complaint for the return of their land title, sum of money, and damages. The RTC issued a preliminary injunction enjoining the foreclosure, and later rendered a judgment in favor of the petitioners, ordering the return of the overpaid amount, the land title, payment of attorney's fees, and costs. On appeal, the Court of Appeals reversed the decision, stating that partial payments should be applied first to the interest, and that the stipulated monthly interest of 5% should apply to the entire duration of the loan.

ISSUES:

1. Whether the monthly interest of 5% applies only to the 3-month effectivity period of the loan.

2. Whether the partial payments made by the petitioners should be applied first to the interest and then to the principal.

RULING:

1. The Court of Appeals held that the stipulated monthly interest of 5% should not apply only to the 3-month effectivity period of the loan. It ruled that such an interpretation would sanction the irregular performance of one's obligation. The borrowers would be encouraged not to pay their loan within the agreed period because they would only have to pay a lower 1% monthly interest after the 3-month period. The Court found this interpretation to be unfair and unjust to the creditors.

2. The Court of Appeals held that partial payments should be applied first to the interest and then to the principal. It based its ruling on the provision in the New Civil Code that states that if the debt bears interest, payment of the principal shall not be deemed to have been made until the interest has been covered. The court found no support for the trial court's decision to apply the partial payments to the principal loan without fully satisfying the accumulated interest.

PRINCIPLES:

• Partial payments should be applied first to the interest and then to the principal.

• If the debt bears interest, payment of the principal shall not be deemed to have been made until the interest has been covered.