When Interest Rates Become Penalties

DATE PUBLISHED: March 20, 2024

key takeaways

Determining interest rates, in particular default rates, should involve careful consideration of what is reasonable and what is necessary to compensate a lender for loss suffered.
Interest rates should be reviewed to ensure that they are reasonable and not of an amount that would constitute a penalty imposed on the borrower.
The consideration of whether the interest rate is a penalty is highly factual and dependent on the circumstances of each arrangement.

Whether or not an interest rate is a penalty is a genuine concern because if you get it wrong and where it is a penalty, it will be void.

What is a penalty?

Where a proposed rate of interest is so disproportionate as to be unconscionable, the contractual provision is considered a penalty. It is not enough that the provision is simply lacking proportionality, it must be wholly out of proportion.

Recent Decision

Recently the Queensland Supreme Court was required to consider whether an interest rate of 20% per annum compounding daily was a penalty. The circumstances involved a contractual dispute and the parties’ agreement to delay payment for services.

In the circumstances, the court determined the interest rate of 20% was not a penalty. The most influential reason for the decision was that the provision was designed to reasonably protect the commercial interests of the lender/provider of financial accommodation, and not designed to punish the borrower/recipient of the financial accommodation.

How to determine if interest rate provisions are penalties?

Despite the above decision, there are circumstances where a rate of 20% per annum compounding daily interest would be considered a penalty. This is because it is a highly factual consideration that is intertwined with each specific circumstance. The following table compares some factors that are relevant when considering if your interest rate is a penalty:

More likely to be a penalty	Less likely to be a penalty
Rate is not a genuine pre-estimate of damages suffered by the lender/provider of financial accommodation	Rate is a genuine pre-estimate of damages which may be suffered by the lender/provider of financial accommodation
Nature of the “fee” is for non-payment or to secure an obligation already secured by other means	Nature of the “fee” is for an additional obligation or to reasonably protect commercial interests
The purpose of the clause is to punish or threaten	The purpose of the clause is to protect legitimate commercial interests
Unequal distribution of power, favouring the lender/financial accommodation provider	Equal distribution of power between the parties
Provision decided by one party and forced upon the other	Provision negotiated by the parties
The lender/financial accommodation provider is more sophisticated than the borrower/recipient of the financial accommodation	Both parties have equal sophistication

An issue to be kept in mind is that provisions which could constitute penalties can take different forms, including:

Fees to secure obligations: these will almost always be struck down by the courts, whereas a fee for further services (even if substantial) may not be considered a penalty.
Late payment fees: these can be enforceable provided they are proportional to the interest being protected by their imposition.
Acceleration clause: where the predominate purpose of accelerating is to punish an obligor for bringing about termination, the provision will be considered a penalty, especially where the sum is wholly out of proportion to loss suffered by the party enforcing the clause.
Higher and lower interest rates: tiered interest provisions, if they reflect appropriate commercial decision, are not usually considered penalties.

Conclusion

While these considerations are nothing new, everyone should be reminded of the risk of interest rates constituting penalties.

We recommend reviewing your interest rate provisions to check their commerciality and whether they are suitable in the circumstances. If you don’t, you run the risk of being unable to enforce them.