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It would indeed be a strange loan contract if there were no provision for the payment of interest by the borrower on the outstanding amount, and this interest rate will generally increase if the borrower defaults on payment.
But can a lender impose any default interest rate it wants? The short answer is no. Although a higher interest rate is acceptable in case of default; Justified by the increased credit risk assumed by the lender, an abnormally high late interest rate could be considered a penalty and in fact be unenforceable by the lender, as this recent case shows.
In short, the borrower (Ahuja) had purchased a property from the lender (Victorygame), which was partly funded by a loan from Victorygame. Ahujua later defaulted on a payment under that loan, alleging misrepresentation.
The loan agreement specified that in the event of default (such as non-payment), the interest rate would be capitalized on a monthly basis at a rate of 12% per month, a rate which represented an increase of 400 % compared to the pre-default rate assess.
law and decision
Case law surrounding default interest rates has established that to avoid the risk of the interest rate being characterized as an unenforceable “penalty”, the default interest rate should not be too high and should only accrue that the fault persists. But what is considered “too high”?
In the Ahuja case, the High Court conducted the analysis in two stages:
First, it examined whether the clause in question imposed a “primary obligation”, which is essentially an obligation for the contracting parties to perform their contractual promises, as opposed to a “secondary obligation”, which is a requirement which arises from the fact of law relating to the breach of a primary obligation. If classified as a primary bond, the interest rate could not be a penalty. The court, however, found that the way the loan agreement was drafted made it clear that the clause was intended to impose a secondary obligation rather than a primary obligation in the event of default.
The tribunal then considered the “legitimate interest” test, ie whether the obligation imposed was disproportionate to any legitimate interest. The judge accepted that a defaulting borrower carries 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 business interest in charging 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 charged reflected a “genuine assessment of Ahuja’s creditworthiness in the event of default” , the High Court found that the default interest rate was “so grossly extravagant, exorbitant and oppressive”, that it categorized it as a penalty and was therefore unrecoverable by Victorygame.
The court suggested that if the default interest rate had been lower (e.g. at a rate of 200% or less), the court might have been prepared to accept, without further evidence, the provision as “non-criminal” to reflect the greater credit risk presented by a defaulting borrower. However, any larger increase would require compelling justification.
As a borrower, make sure you understand the agreed interest rate provisions and the maximum amount of interest that could be due on any unpaid sum, particularly if an event of default occurs .
Lenders should be aware that although higher interest rates are likely to be enforceable against a defaulting borrower, there are limits on the amount of such rates, particularly if there is no is no evidence justifying the higher rate. If Victorygame had provided a true assessment of Ahuja’s creditworthiness and highlighted particular factors affecting the credit risk posed or market interest rates at the time of entering into the loan agreement, they might have be able to get away with it.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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