Loan agreement default interest rates: How much is too much?

It would be a strange loan agreement indeed if there was no provision for the payment of interest by the borrower on the amount outstanding, and this rate of interest will generally increase if the borrower defaults on a payment.

But, can a lender impose any default interest rate they wish? The short answer is no. Although a higher interest rate is acceptable where there has been a default; justified by the increased credit risk taken on by the lender, an unusually high default interest rate could be deemed a penalty and actually be unenforceable by the lender as this recent case shows.

The facts

In brief, the borrower (Ahuja) had bought a property from the lender (Victorygame), which was partly funded by a loan from Victorygame. Ahujua subsequently defaulted on a payment under this loan, alleging misrepresentation.

The loan agreement specified that in the event of default (such as non-payment), the interest rate would be compounded on a monthly basis at a rate of 12% per month, a rate which represented a 400% increase on the pre-default rate.

The law and decision

Case law surrounding default interest rates has established that to avoid the risk of the interest rate being classified as an unenforceable ‘penalty’, the default interest rate should not be too high and should only run while the default continues. But, what is deemed as “too high”?

In the Ahuja case, the High Court undertook the analysis in two stages:

First, it considered whether the clause in question imposed a ‘primary obligation’, which is essentially a requirement for the contracting parties to carry out their contractual promises, as opposed to a ‘secondary obligation’, which is a requirement that arises by operation of law on the breach of a primary obligation. If classed as a primary obligation, the interest rate could not be a penalty. The court found however, that the manner in which the loan agreement was drafted clearly showed that the clause was meant to impose a secondary, rather than a primary, obligation in the event of breach.

The court then considered the ‘legitimate interest’ test, i.e. whether the obligation imposed was out of all proportion to any legitimate interest. The judge accepted that a defaulting borrower comprises an increased credit risk for the lender and as such, a higher default interest rate is more acceptable; in such a situation, the lender has a “legitimate commercial interest in applying a higher rate”. However, even though Ahuja did not provide evidence of market interest rates and Victorygame did not provide evidence to show that the rate imposed reflected a “genuine assessment of Ahuja’s creditworthiness in the event of default”, the High Court found the default interest rate was “so obviously extravagant, exorbitant and oppressive”, that it categorised it as a penalty and was therefore irrecoverable by Victorygame.

The court suggested that had the default interest rate been lower (for example at a rate of 200% or less), then the court might have been prepared to accept, without further evidence, the provision as ‘non-penal’ to reflect the greater credit risk presented by a defaulting borrower. However, any greater increase would require evidential justification.

Tips

As a borrower, ensure that you fully understand the interest rate provisions agreed and the maximum amount of interest that could be payable on any outstanding sum, particularly if an event of default arises.

Lenders should be aware that although higher interest rates are likely to be enforceable in respect of a defaulting borrower, there are limits as to how high such rates should go, particularly if there is no evidence to justify the higher rate. If Victorygame had provided a genuine assessment of Ahuja's creditworthiness and evidenced particular factors affecting the credit risk posed or market interest rates at the time of entering into the loan agreement, they may just have got away with it.

If you would like further information about anything covered in this article, please contact our Banking team.

Disclaimer

This note reflects the law as at 31 August 2022. The circumstances of each case vary and this note should not be relied upon in place of specific legal advice.