It is fairly common for lenders to charge higher rates of interest when a borrower is in default. However, doing so carelessly can lead to trouble.
In Aquamore Credit Equity Pty Ltd v Hung, the NSW Supreme Court considered a disputed loan agreement that provided for interest of 2.5% per month when the borrower was not in default and provided for interest of 5% per month if the borrower was. The borrower argued that the default interest rate was a penalty and was unenforceable.
At law, a ‘penalty’ is a contractual provision that imposes consequences for breach of an obligation or the happening of an event. Penalties are only enforceable to the extent necessary to compensate the other party for their losses flowing from the breach.
In Aquamore, the court found that there was no proper justification for such a significant increase in the interest rate on default (from 30% per annum to 60% per annum), that the clause was therefore a penalty and was unenforceable. Aquamore was unable to recover interest from the borrower except at the 30% per annum rate.
As the decision shows, lenders need to be careful when structuring and documenting their loans. As always, good advice early can prevent significant problems down the track. In particular, careful drafting of loan agreements can minimise or eliminate the risk of clauses (including default interest rates) being unenforceable as penalties.
If you have any questions about lending, give our loans and securities solicitor Jay a call on 02 6650 7016.
