A penalty for your thoughts: default interest rate found to be penal

Loan and covenant

An unregulated lender lent to Mr and Mrs Houssein (via a corporate borrower of which the Housseins were directors and shareholders). The lender was not authorised to make loans to individuals secured by way of a mortgage over residential property in which those individuals resided. Accordingly the loan included a covenant that the Housseins could not reside in the family home that was part of the security.

Under the loan agreement, on an event of default or late payment, the lender was entitled to impose default interest by increasing the interest rate from 1% per month to 4% per month.

The lender argued the no residency covenant was breached and sought to enforce the default interest clause. The Housseins argued the lender had waived the breach and that a 4% per month default rate was a penalty and therefore unenforceable. The parties agreed that whether there was a waiver turned on the lender's awareness that the Housseins were living at the premises on a certain date. The parties also agreed that if there was a waiver it would be by election and so would extinguish the lender's right to insist on non-residence.

The court found the lender had waived the no residency covenant but considered the default interest rate in any event. This was because there was an additional provision relating to failure to pay which could apply if sums remained outstanding after a certain date. 

Penalty for default interest

To determine the enforceability of the default interest rate, based on the test in Cavendish v Makdessi, the court asked itself whether the default rate protected a “legitimate interest” of the lender. The court decided that the legitimate interest could not be the no residency requirement since the purpose of that provision was to ensure compliance with the Financial Services and Markets Act 2000.

The court accepted that charging a higher rate on default could be commercially justified based on an enhanced credit risk. On the facts before it, the court found the lender’s legitimate interest could not be the Housseins’ credit risk:

1. The credit standing of the Housseins was already priced into the original interest rate. A previous additional credit risk had justified an earlier increase of 0.3% from 0.7% to 1%. A further increase of 3% could therefore not be justified.
2. The default rate was set without reference to the borrower or the particular loan.
3. The same default rate applied to all breaches under the loan agreement.
4. A typical default rate would be 3% per month and nothing justified the additional 1%.

Judgment: Houssein v London Credit

Update December 2023: case is on appeal