Default Interest: a Worked Example

A borrower that has missed a payment is a worse risk than the one the lender priced. The chance of loss has gone up, the file needs more of the bank's time, and a downgrade of the borrower's rating can raise the capital the bank must hold against the loan. The uplift recovers part of that and gives the borrower a reason to pay this lender before creditors who charge nothing for waiting.

That is also the reasoning courts have accepted. The UK Supreme Court, in its 2015 restatement of the penalty rule, discussed the English decisions that had upheld a modest increase in the rate after default as reflecting the greater credit risk of a borrower in default, and drew from them the point that a party can have a legitimate interest beyond recovering its loss.

Four parts decide what a borrower pays. The trigger is either a missed payment or, in broader clauses, any event of default, including a covenant breach where nothing is overdue. The base is either the unpaid sum alone or the whole amount outstanding. The uplift is stated in percentage points above the rate that would otherwise apply: often one point in syndicated agreements, more in some business-banking terms. And the period runs from the due date or the default until payment or remedy, and in many agreements default interest left unpaid is rolled into the debt each time an interest period ends, so it compounds.

A glasshouse vegetable grower, constructed for this page like every figure in it, has a term loan of US$6.0m at 7.2%, repaid quarterly. On 31 March it misses an instalment of US$258,000: US$150,000 of principal and US$108,000 of interest. It pays 45 days later. Two versions of its facility letter, with uplifts chosen for the example:

Under clause A the grower pays US$2,926 for keeping US$258,000 for 45 days, and only US$636 of that is the price of the default. Under clause B the same 45 days cost thirty-five times as much in uplift, because the higher rate runs on the balance that was not late. The last line is the case borrowers least expect: a broad clause can charge default interest for months on a loan on which every payment has been made, while the parties negotiate a waiver of a breached covenant.

A late-payment fee is a fixed sum for a missed date; default interest grows with the amount and the days. A limit excess charge on an overdraft prices borrowing beyond the agreed limit, usually without any default being called. A margin increase after an annual review, or under a margin ratchet, is a change to the agreed price for the rest of the loan. Default interest is temporary by design: it belongs to the default and normally stops when the default is remedied or waived.

Its limit is the penalty rule. In England a provision triggered by breach is unenforceable if the detriment is out of all proportion to the lender's legitimate interest in performance, and in 2026 the Court of Appeal declined to disturb a trial judge's finding, made on that test, that a default rate taking interest from 1% to 4% a month, compounded, on a twelve-month secured loan was not a penalty. New Zealand's Supreme Court adopted the same proportionality question in 2020, and the High Court of Australia's 2016 decision on card late-payment fees turned on similar reasoning, though Australian law can also reach a charge triggered by something other than breach.

DEFINED IN ONE PARAGRAPH → · READING YOUR FACILITY LETTER → · PRICING AND FEES →

At signing, the clause is often one of the easier points for a borrower to negotiate, because a lender that does not expect a default gives up little by agreeing. The points that matter are the base (overdue amounts only), the trigger (payment defaults, not every event of default), a short period before it starts, and no compounding. A borrower that reads the clause before it is needed can save the example's US$60,000.

After a default, the clause becomes a lever. A lender drafting a waiver or a standstill decides whether to charge default interest, waive it, or accrue it and forgive it if the borrower meets the agreed plan, and the choice tells the borrower how the bank is reading the file. A lender that charges it from the first day on a borrower trying to recover can push cash out of a business that needs it, and the senior question is whether the uplift helps the recovery or only the account. Guarantors read it too: an all-monies guarantee commonly reaches default interest, inside or on top of its limit as the document says.

WHEN YOUR LOAN GOES TO WORKOUT → · COVENANT RESET → · PERSONAL GUARANTEES →