It's important to understand default interest rate clause. In the event a party fails to fulfill the obligations as set forth in an agreement, a higher interest rate will be incurred and this will result in a higher total amount due. This higher rate of interest is referred to as the default interest. It is a standard practice to include a default interest clause in most loan agreements, settlements, and commercial agreements.

For instance, if the original loan interest rate in an agreement is 6.24 percent per annum, and the borrower misses a payment, the loan may include a clause which would require the borrower to continue to pay the loan at a higher rate of 11.24 percent until the loan is paid in full. The blameless party must set the default interest at a reasonable amount that would reflect a genuine pre-estimate of the loss incurred.

What Factors Impact Interest Rates?

  • The current interest rate charged by major lenders
  • The economic climate
  • The industry
  • The nature of the business

These are all factors that are taken into consideration when determining a reasonable interest rate.

The default interest is not to be used as a penalty against the defaulting party. This is not the purpose of a default interest clause and it is against the law to be used as such. For punitive purposes, punitive default interest rate clauses are put in place as a means to deter the debtor from breaching the contract. The consequences are usually discouraging enough to cause the debtor to make every effort in fulfilling all obligations.

When Is the Default Interest Rate Clause Enforceable?

Even if agreed upon at the outset of the agreement, when a default interest clause is included as a form of penalty, it is not a forcible clause. If a payment is missed or late, a legal fee may be enforced to compensate the lender for any internal expenses incurred in administering the late payment. The late fee is most often expressed as a percentage or a flat fee.

When a default interest provision is included, a higher interest rate will be incurred and remain in effect for the remainder of the loan until the default is cured. The default interest provision is meant to compensate the lender for the missed opportunity for reinvestment of proceeds and for the lenders increased risk of dealing with an unreliable borrower.

It is important that the lender set the default rate as fair and reasonable to ensure the provision is enforceable and not ruled or considered to have set at a rate of penalty. Most courts will determine if the contractual term is penal or if the clause is enforceable by examining whether there was a genuine attempt to estimate the actual loss that might be incurred if there was a breach in obligations.

How Does English Law View Increased Interest Rates?

As long as the increased rate of interest is not unreasonable, English law will commonly uphold the default interest clause even if pre-estimates are not exactly genuine.

A loan which has gone into default is often viewed as a defense for a lender charging a higher interest rate. This is due to more time and expenses being involved for administration and monitoring purposes. In addition, when a lender's risk is enhanced due to nonpayment, the lender is forced to take on credit risk and this serves to justify a higher rate of interest, as well.

Out of respect for default interest provisions, most courts will not strike out a specified amount as being penal, or at least not on the sole basis of the amount specified being greater than the actual loss.

In Cavendish Square Holdings BV vs Makdessi (2012) EWHC 3582, the modern approach is confirmed when the courts ruled that focusing on whether the rate is commercially justifiable in the circumstances of the transaction is what matters rather than whether the rate reflects a genuine pre-estimate of loss.

Questions Asked When Determining Whether an Interest Rate Is Penal

When determining whether a rate is penal or not, most judges will ask four questions:

  • Is there a commercial justification for the rate?
  • Is the rate extravagant or oppressive?
  • Was there a level playing field at negotiations?
  • Was the rate set for the purpose of deterring a breach?

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