Are Loan Interest Clauses Fair or Punitive Penalties?

Interest clauses in loans serve the fundamental purpose of offering a return to a lender on the capital they make available to a borrower.

They also serve a secondary purpose of compensating for the opportunity cost associated with delayed payments to the extent that a borrower defaults. 

Myerson Solicitors' banking lawyers discuss interest calculation, the enforceability of interest, and the case of Houssein v London Credit [2023].

How do you calculate interest?

Interest can be calculated in a number of ways, including one or a combination of the following: 

• Simple interest - calculated solely on the principal amount over a specific period at a fixed rate.  
• Compound interest – calculated on both the initial principal loan and the accumulated interest over time, resulting in interest being charged on interest. 
• Variable - calculated by reference a specified rate, such as the Bank of England base rate or SONIA (Sterling Overnight Index Average), plus a margin. 

Default interest, on the other hand, is an additional rate applied over and above the standard interest rate, charged when a borrower fails to meet their payment obligations, incentivising timely repayments and compensating lenders for the increased risk.

It serves as a deterrent against defaulting on loans or debts, as well as providing a mechanism for creditors to recoup losses.

The enforceability of interest clauses has been subject to scrutiny in the UK, particularly concerning their classification as penalty clauses.

In the case of Cavendish Square Holding BV v Makdessi [2015] UKSC 67 (involving a dispute over the enforceability of certain clauses in contracts related to the sale of shares in a company), the court held that a clause will be considered a penalty if it imposes a detriment on the defaulting party that is extravagant, unconscionable, or disproportionate to the legitimate interests of the innocent party.

Houssein v London Credit [2023] has provided specific insight into the application of these principles to interest clauses, particularly in the context of consumer credit agreements.

The case involved an unregulated lender who loaned money to Mr and Mrs Houssein to re-finance an existing bridging loan secured against three of the five buy-to-lets.

The terms of the loan included a covenant that the Housseins could not to occupy the property and that in the event of a default, a receiver could sell the properties and default interest of 4% would accrue.

The lender argued that the Housseins were living in their own home and commenced charging the default interest of 4%. 

The lender appointed receivers to sell the mortgaged properties.

The Housseins denied there had been any material breach and sought an injunction to restrain the sale.

On the facts, it was found that the non-residence requirement had been waived by the lender so there was no event of default.

However, the court went on to consider whether the default interest rate in the event of late payment was a penalty.

The court held that there was concern over the way the loans had been obtained and whether the purpose of enforcement was to impose an oppressive rate of interest. 

It was found that the default interest rate was unenforceable since there had been no default.

The court considered whether the default rate protects the legitimate interest of the lender.

It was found that interest could not be the no residency requirement, as the purpose of that provision was to prevent a breach of the Financial Services and Markets Act 2000. 

Accordingly, whilst charging a higher rate of interest on default can be commercially justified, in this case, there was no credit risk to the borrower as:

• A level of credit risk had already been factored into the lender’s rate.
• The default rate was the same without reference to the borrower or the particular loan. No account was taken of the security.
• The same default applied to all breaches.
• A more typical default rate, would be 3% and, the court found in the context of the above points, there was no further justification for the additional 1%.

As it stands, the Houssein v London Credit case is in the process of being appealed and is due to be before the Court of Appeal on 23 May 2024.

In light of these recent developments, lenders must exercise caution when drafting interest clauses to ensure they are not construed as penalty clauses.

It is essential for such clauses to be commercially justified, proportionate, and reflective of genuine pre-estimated losses rather than a punitive measure.

Failure to adhere to these principles may render the interest clause unenforceable and expose parties to legal risks.