When things go wrong in lending relationships, a lender will often reach for the default interest clause – being a higher rate of interest charged on overdue sums. It is meant to protect the lender against increased risk, administrative effort, and the loss of use of funds. However, the law draws a fine line between a legitimate deterrent and a penalty clause, which the courts will not enforce. In practice, this means that while lenders may seek to impose default interest as a safeguard, the courts may scrutinize whether the clause is proportionate to the lender’s actual loss or merely punitive in nature. If the latter, the clause risks being struck down as unenforceable, leaving the lender unable to recover the additional sums.
The courts apply a clear test when deciding whether a default interest clause amounts to an unenforceable penalty: does it impose a burden that is out of all proportion to any legitimate interest the lender has in enforcing the contract? Put differently, the law is not concerned with punishing the borrower, but with ensuring that the clause does not exceed what is commercially defensible. For a lender, this means that a default rate cannot simply operate as a stick to deter late payment; it must be grounded in genuine commercial justification, reflecting the increased credit risk, administrative costs, and loss of liquidity that arise when a borrower defaults (Cavendish Square Holding BV v Talal El Makdessi[2015] UKSC 67).
The position was once again revisited in 2024, in a case involving a bridging loan with a standard interest rate of 1% per month and a default rate of 4% (Houssein v London Credit Ltd[2024] EWCA Civ 721). The court emphasised that a lender does have a legitimate interest in enforcing timely repayment and protecting against the additional risk involved when a borrower defaults, however, the key issue is proportionality. A well-reasoning default interest clause can survive scrutiny, provided it is commercially grounded.
Example:
In Ahuja Investments Ltd v Victorygame Ltd [2021] EWHC 2382 (Ch) – the High Court struck down a default interest rate of 12% per month as an unenforceable penalty. The court found the rate to be extravagant and not proportionate to any legitimate interest of the lender, highlighting the importance of ensuring that default interest rates are reasonable and justifiable.
For lenders, the takeaway is simple, default interest provisions are not “set-and-forget” boilerplate clauses. They need commercial logic, careful drafting, and clear evidence of justification.
Key considerations for lenders:
- Legitimate interest – Make sure the clause protects a real commercial interest, for example, the risk of delayed recovery or the administrative burden of default.
- Proportionality – Keep the default rate within a reasonable range, avoid high rates which can’t be justified by genuine commercial factors.
- Evidence – Keep records showing how the default rate was determined (including market comparisons, risk assessments).
A well drafted default interest clause can protect your lending business, but a poorly drafted one could cost you more than you think.
If you need assistance reviewing your lending agreements, assessing enforceability or documenting borrower or lender arrangements contact us.
