Default interest is a higher interest rate which is payable if a party to an agreement fails to fulfil an obligation to the other party. Typically, commercial arrangements, settlements and the vast majority of loan agreements contain default interest clauses.
Default interest clauses are often seen in the standard terms of a loan agreement. The ordinary interest rate in a loan agreement might be 6.24% per annum. If the borrower was to miss a repayment, the agreement might require that party to pay a higher interest rate of, say, 11.24% on the sum that was not paid.
Default interest must be set at a reasonable commercial rate, which constitutes a genuine pre-estimate of loss to the innocent party in the event of default. Factors material to ascertaining a reasonable commercial rate include the nature of the business, the industry, the economic climate and interest rates charged by major lenders such as banks.
Default interest cannot, by law, be used as a tool to penalise a defaulting party. The term “penalty” applies to punitive default interest rate clauses within a contract. Essentially, this is where a contract is designed to make the consequences of a breach so daunting that a debtor will not default. Default interest clauses which constitute a penalty are unenforceable, even where parties agree to such a clause at the outset of the agreement.