Why Default Interest Clauses Attract Judicial Scrutiny
Default interest clauses sit at the intersection of orthodox contract enforcement and the long-standing judicial concern to prevent contractual sanctions masquerading as compensation.
Although interest is often described as the price paid for the use of money, an increase in interest triggered by default raises qualitatively different legal questions.
The central issue is whether the clause protects a legitimate commercial interest or instead operates to punish non-performance.
Australian courts approach this question through the penalty doctrine, which focuses on substance rather than form.
Default interest clauses are therefore not assessed merely by their label or by the fact that they apply automatically upon default.
Instead, courts examine whether the additional financial burden imposed on default is properly characterised as compensatory or as penal.
This concern reflects the High Court’s settled understanding of penalties in contract law. In Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30, the Court described the essential nature of a penalty obligation in the following terms, as stated at [9]:
As the term suggests, a penalty is in the nature of a punishment for non-observance of a contractual stipulation and consists, upon breach, of the imposition of an additional or different liability.
That formulation explains why default interest provisions are frequently contested. A higher rate of interest imposed only because a borrower has failed to comply with a payment obligation may, depending on its operation and magnitude, amount to an additional or different liability imposed for default rather than a genuine adjustment for increased risk or cost.
The High Court in Andrews v ANZ also cautioned against treating freedom of contract as an overriding value that displaces equitable and statutory controls. In the same judgment, the Court observed at [5]:
This pattern of remedial legislation suggests the need for caution in dealing with the unwritten law as if laissez faire notions of an untrammelled ‘freedom of contract’ provide a universal legal value.
That caution has particular relevance to default interest clauses, which are often drafted by lenders and applied across multiple transactions.
Courts therefore scrutinise not only the contractual language, but also the commercial rationale said to justify the interest uplift.
At the same time, Australian appellate authority makes clear that default interest is not presumed to be unenforceable merely because it exceeds the ordinary contractual rate.
The assessment is forward-looking and directed to the position at the time of contract formation. In Arab Bank Australia Ltd v Sayde Developments Pty Ltd (2016) 93 NSWLR 231, the New South Wales Court of Appeal emphasised that point at [2]:
The stipulated default rate of 2% could not be regarded as extravagant or unconscionable. The costs taken into account were real and were foreseeable at the time the contracts were entered into.
The Court also rejected any strong presumption that a default interest clause is penal, stressing the need for evidence-based characterisation at [3]:
The presumption that the stipulation is a penalty is a ‘weak’ presumption, and the characterisation of the stipulation should be considered by reference to available evidence.
Recent first-instance authority confirms that these principles continue to guide judicial scrutiny.
In Bellas v Powers [2023] NSWSC 1198, the Supreme Court of New South Wales considered a facility agreement that applied a discounted rate where no event of default subsisted and a higher standard rate upon default.
The case illustrates the modern approach of examining the economic substance and commercial justification of interest differentials, rather than treating rate increases on default as inherently penal
This section frames the broader analysis that follows. Australian courts neither treat default interest as inherently suspect nor enforce such clauses automatically.
Instead, claims for default interest are subjected to scrutiny grounded in the penalty doctrine, informed by commercial context, and directed to distinguishing legitimate compensation from contractual punishment.
What is “Default Interest” in Contract Law?
In Australian law, the term “default interest” has no fixed technical meaning. Courts do not treat it as a distinct doctrinal category.
Instead, it is analysed by reference to the contractual structure in which it appears and the function it performs.
Typically, default interest refers to an increased rate of interest that becomes payable upon the occurrence of an event of default, most commonly a failure to make a payment when due.
However, whether such an obligation is enforceable depends not on its description, but on its legal character.
The High Court has repeatedly emphasised that the penalty analysis turns on substance rather than form.
In Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30, the Court explained that a penalty arises where a contractual stipulation is collateral to a primary obligation and imposes an additional detriment upon failure of that primary obligation at [10]:
In general terms, a stipulation prima facie imposes a penalty on a party … if, as a matter of substance, it is collateral (or accessory) to a primary stipulation … and this collateral stipulation, upon the failure of the primary stipulation, imposes upon the first party an additional detriment.
This framework is directly engaged by default interest clauses. Ordinary contractual interest is part of the primary obligation to pay for the use of money.
By contrast, default interest generally applies only upon non-performance of the primary obligation.
Whether the increased rate is collateral or primary depends on how the contract is structured and how the obligation is triggered.
Courts therefore distinguish between clauses that genuinely define the price of credit over time and clauses that operate only as a consequence of default. This distinction is not resolved by drafting technique alone.
Even where a contract presents alternative interest rates, courts examine whether the higher rate is, in substance, imposed because of default.
That approach is illustrated by an appellate authority considering concessional and standard interest structures.
In Kellas-Sharpe & Ors v PSAL Limited [2012] QCA 371, the Queensland Court of Appeal addressed a loan agreement providing for a higher standard rate and a lower concessional rate where the borrower was not in default. The Court framed the issue as one of substance, not terminology:
This appeal raises the interesting question of whether such a clause is a penalty with the consequence that the interest rate provision is void.
The case confirms that even where a contract is drafted as offering alternative rates, courts will look beyond form to determine whether the higher rate is effectively imposed as a consequence of default.
Compensatory Versus Penal Character
Once a default interest clause is characterised as operating upon default, the critical question becomes whether it is compensatory or penal in nature. The penalty doctrine is engaged where a clause is directed to punishment rather than compensation.
The High Court has consistently described a penalty as being concerned with punishment rather than recovery of loss.
In Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30, the Court adopted the long-standing formulation that a penalty operates in terrorem to secure performance rather than to compensate for loss, as stated at [10]:
In that sense, the collateral or accessory stipulation is described as being in the nature of a security for and in terrorem of the satisfaction of the primary stipulation.
Applied to default interest, this means that an increased rate will not be penalised merely because it is high.
The question is whether the rate can be justified as protecting a legitimate interest of the lender, such as increased credit risk, administrative burden, or funding costs arising from default.
The High Court’s emphasis on proportionality and justification is reinforced by Ringrow Pty Ltd v BP Australia Pty Ltd [2005] HCA 71, where the Court warned against too readily intervening in commercial bargains, while still recognising limits at [11]:
The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach …
Although Ringrow v BP Australia did not concern interest rates, that formulation has been repeatedly applied to default interest claims.
It frames the inquiry in terms of the proportionality between the stipulated consequence of default and the legitimate interests purportedly protected.
Modern appellate authority confirms that the assessment is undertaken by reference to the circumstances existing at the time the contract was made, not with hindsight.
Recent first-instance decisions demonstrate how this distinction is applied in practice. In Bellas v Powers [2023] NSWSC 1198, the Court was required to determine whether a higher standard rate applied upon default was unenforceable as a penalty, reinforcing that the inquiry turns on substance, justification, and proportionality rather than on the mere existence of an interest uplift
Taken together, these authorities show that Australian courts do not approach default interest as inherently suspect.
Instead, they focus on whether the clause operates as a genuine incident of the lender’s commercial bargain or whether it crosses the line into punishment for non-performance.
That characterisation underpins the enforceability of default interest claims and informs the analysis in the sections that follow.
Statutory Framework Governing Interest Claims
Claims for default interest must be distinguished from the court’s independent statutory power to award interest.
In Australian jurisdictions, that power is typically conferred by civil procedure legislation and operates as a discretionary remedial mechanism rather than as a contractual entitlement.
Its existence does not validate a contractual interest clause, nor does it displace the need to determine whether a contractual default rate is enforceable.
The statutory framework is frequently engaged where contractual interest is disputed, unenforceable, or where interest is sought for periods not expressly governed by contract.
This distinction is apparent in cases where plaintiffs plead statutory interest as an alternative to contractual default interest.
In Bhundia v Sommers (No 4) [2021] NSWSC 455, Adamson J described the statutory basis on which interest was claimed, separate from the contractual provisions said to be penal, as stated at [1]:
By statement of claim filed on 23 July 2019, [the plaintiff] claims the sum of US$925,076.38 … together with interest under s 100 of the Civil Procedure Act 2005 (NSW).
The case illustrates that statutory interest is pleaded and considered independently of contractual default interest, particularly where the enforceability of the contractual rate is contested.
Purpose and Function of Statutory Interest
Statutory interest provisions are directed to compensating a successful party for being kept out of money to which they were entitled, rather than to enforcing the parties’ contractual allocation of risk.
That purpose has been repeatedly emphasised by appellate courts when explaining the rationale for awarding interest as part of judicial relief.
In Najdovski v Crnojlovic (No 2) [2008] NSWCA 281, the New South Wales Court of Appeal explained the function of pre-judgment interest under the statutory regime at [7]:
The general provision for the inclusion in an award of damages of an amount by way of interest is to be found in the Civil Procedure Act, s 100.
The Court further explained that interest awarded under statute is tied to the period during which a party has been deprived of the use of money, rather than to the enforcement of contractual sanctions, at [5]:
If the effect of the judgment is back-dated, that will not be appropriate, but the plaintiff will be entitled to post-judgment interest until the relevant amount is paid.
This reinforces the compensatory nature of statutory interest and underscores its conceptual separation from default interest imposed by contract.
Interaction Between Statutory Interest and Contractual Default Interest
Courts are often required to consider the interaction between statutory interest regimes and contractual default interest clauses.
The presence of a statutory power to award interest does not mean that contractual interest will be enforced without scrutiny, nor does it permit parties to avoid the penalty doctrine by reframing default interest as a statutory claim.
Where a contractual default interest clause is found to be unenforceable, statutory interest may still be awarded, but only in accordance with the relevant legislative criteria and discretionary considerations.
Conversely, where contractual interest is enforceable, statutory interest will generally play a residual role.
This interaction was evident in Bhundia v Sommers (No 4) [2021] NSWSC 455, where contractual default interest was squarely challenged as a penalty, but statutory interest was claimed in the alternative, as stated at [2]:
… the first defendant filed an amended defence in which he admitted the loan and the guarantee, did not admit that he received the notices of demand, admitted that he had not repaid the amount claimed, and alleged that the operative provisions of the transactional documents (addressed below) are void and unenforceable as penalties.
The case demonstrates that statutory interest does not operate as a substitute for an invalid contractual clause, but as a separate source of judicial relief where appropriate.
Limits of Statutory Intervention
Although statutory provisions confer broad powers on courts to award interest, those powers do not authorise the court to rewrite the parties’ bargain or to enforce a default interest clause that fails at common law.
The statutory regime operates within, not outside, the boundaries set by doctrines such as penalties and unconscionability.
As the appellate authority makes clear, the interest awarded under the statute remains subject to the structure and effect of the judgment itself.
In Najdovski v Crnojlovic (No 2) [2008] NSWCA 281, the Court of Appeal emphasised that interest questions may need to be resolved separately where disputes remain, as stated at [6]:
Any dispute as to the quantum of interest would need to be determined in debt recovery proceedings, which are not to be anticipated.
This confirms that statutory interest does not automatically resolve controversies surrounding interest claims and does not preclude careful analysis of contractual default interest provisions.
Common Law Principles Applied by Courts
At common law, the enforceability of default interest clauses is primarily assessed through the penalty doctrine.
The doctrine does not prohibit all consequences of breach, but it limits contractual stipulations that impose consequences disproportionate to the legitimate interests protected by the contract.
Courts, therefore, focus on whether the clause operates to secure performance by threat rather than to compensate for anticipated loss or risk.
The High Court has consistently emphasised that the penalty inquiry is concerned with substance rather than drafting technique. In Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656; [2005] HCA 71, the Court articulated the threshold for intervention in emphatic terms:
It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach …
Although Ringrow v BP Australia did not concern interest rates, this formulation has been repeatedly adopted in cases assessing default interest clauses.
It establishes that courts do not ask whether the clause produces hardship in the particular case, but whether it was exorbitant by reference to foreseeable consequences at the time of contracting.
That forward-looking assessment is particularly significant in default interest cases, where the rate is often fixed before any default occurs and is intended to address increased risk, delay, and enforcement cost.
Courts, therefore, resist ex post facto reasoning that focuses on the severity of the outcome rather than the legitimacy of the clause at inception.
Similarly, courts have been attentive to whether interest clauses are structured as genuine alternative primary obligations or whether they operate only upon breach. That distinction is often determinative.
Legitimate Interests and the Limits of Compensation
A critical aspect of the modern penalty analysis is the distinction between compensation for loss and protection of legitimate contractual interests.
Courts have repeatedly emphasised that a party enforcing a contractual stipulation is entitled to recover only loss arising from the breach, and not loss attributable to its own election to terminate or enforce security.
This principle is articulated with clarity in Amev-UDC Finance Ltd v Austin [1986] HCA 63. In explaining the consequences of a finding that a contractual stipulation is a penalty, Gibbs CJ stated at [6]:
It is well established in the modern law that the liability of a party who has broken a contract which contains a penalty clause is to pay the damages that have resulted from the breach.
His Honour went on to draw a firm boundary between loss caused by breach and loss caused by the enforcing party’s own conduct:
In the present case, the additional damage in respect of which the appellant seeks to recover did not result from the breach; it resulted from the determination of the hiring which the appellant itself chose to bring about.
Although Amev-UDC v Austin did not concern default interest as such, these statements are directly relevant to default interest claims.
Where default interest accrues after a lender elects to terminate or accelerate a facility, courts will scrutinise whether the interest claimed truly flows from the borrower’s breach or from the lender’s enforcement decision.
Proportionality and the “Greatest Loss” Concept
The penalty doctrine requires courts to assess whether a stipulated consequence of breach is out of all proportion to the loss that could reasonably have been contemplated at the time of contracting.
This assessment is not mechanical, but it is anchored to the concept of recoverable loss.
In Amev-UDC Finance Ltd v Austin [1986] HCA 63, Gibbs CJ reaffirmed that penalties cannot be justified by reference to outcomes that exceed the loss caused by breach, as further stated at [6]:
The appellant cannot successfully seek to rely on general equitable principles which relate to the relief against penalties when those principles have long since hardened into definite rules governing the position of parties to a contract which contains a clause imposing a penalty for breach.
The Court rejected any suggestion that a penal stipulation could be partially enforced or used as a guide to quantum.
Once characterised as a penalty, the clause could not enlarge the damages recoverable beyond actual loss, as stated at [5]:
The answer to these submissions is that the appellant chose to enter into an arrangement of that kind, and to determine the hiring, and that its election to do so caused this loss.
In the context of default interest, this reasoning supports a careful inquiry into whether the interest rate is calibrated to foreseeable loss or risk, or whether it produces a windfall disconnected from the consequences of default.
Application to High Differential Interest Structures
Cases involving substantial disparities between ordinary and default rates frequently raise questions as to whether the higher rate reflects a genuine commercial response to risk or operates as a deterrent to default.
While Accom Finance Pty Ltd v Mars Pty Ltd [2007] NSWSC 726 is fact-heavy, Windeyer J made findings that are instructive for default interest analysis. In describing the structure of the loan before the Court, his Honour noted at [20]:
The mortgage did set out quite clearly the basic terms of the loan, namely its term of one month, expiry date, principal sum of $320,000, the lower rate of interest of 48% per annum, the higher rate of interest of 96% per annum, and the fact that the interest was compound and paid in advance.
This description illustrates the kind of contractual architecture that attracts judicial scrutiny: a short-term loan, a substantial gap between ordinary and default rates, and compounding interest.
Although the case ultimately turned on statutory and equitable considerations beyond penalties, it demonstrates the factual matrix in which courts examine whether default interest bears a rational relationship to lender risk.
Practical Factors Courts Consider When Assessing Default Interest Clauses
Australian courts assessing claims for default interest do not confine themselves to abstract doctrine.
Once a default interest clause is characterised as operating upon default and engaging the penalty analysis, courts examine a range of practical, evidentiary, and contextual factors to determine whether the clause is enforceable in its application.
Commercial Context and Transaction Structure
A recurring practical consideration is the commercial context in which the default interest clause operates.
Courts consider the nature of the transaction, the urgency of the borrowing, and whether the loan was short-term, high-risk, or contingent on resale or refinancing.
This can be seen in Guardian Mortgages Pty Ltd v Miller [2004] NSWSC 1236, where Wood CJ at CL described the commercial terms of a bridging loan that later became the subject of challenge, as stated at [9]:
If the property is valued by our panel of valuers at $600,000.00 or more, I will provide a loan facility of $125,000.00 for one month to three months at 3% per month.
Although this passage is factual, it illustrates the type of transaction in which courts later scrutinise default interest claims: short-term lending, time pressure, and very high monthly interest rates.
In such cases, courts are alert to whether default interest reflects genuine commercial risk or merely exploits borrowers’ vulnerability.
Relationship Between Default Interest and Borrower Capacity
Courts also examine whether the borrower’s capacity to service the loan made default effectively inevitable.
Where default interest accrues in circumstances where the borrower was never realistically able to meet repayment obligations, courts may scrutinise whether the interest uplift serves a legitimate purpose.
In Elkofairi v Permanent Trustee Co Ltd [2002] NSWCA 413, the Court of Appeal emphasised the relevance of borrower vulnerability and capacity in assessing the fairness of mortgage obligations:
She had no income and this was a large borrowing secured over her only asset. This was apparent to the respondent from the loan application form and sufficient to put the respondent on notice of the appellant’s lack of capacity to meet the mortgage repayments.
While Elkofairi v Permanent Trustee was not a penalty case, its reasoning is often invoked in default interest disputes where lenders rely on strict contractual enforcement despite obvious repayment incapacity.
Evidentiary Justification for the Default Rate
A critical practical factor is whether the lender can explain and justify the default interest rate by reference to increased risk, cost, or disruption caused by default.
Courts are not satisfied by assertion alone; they expect evidence showing a rational connection between the default rate and the lender’s legitimate interests.
The importance of evidentiary justification is consistent with the High Court’s broader insistence that courts evaluate commercial arrangements objectively rather than by hindsight sympathy.
In Australian Securities and Investments Commission v Kobelt [2019] HCA 18, Kiefel CJ and Bell J explained that statutory evaluation of conduct must proceed by reference to objective standards:
The proscription in s 12CB(1) is of conduct in connection with the supply of financial services that objectively answers the description of being against conscience.
Although Kobelt was concerned with unconscionability rather than penalties, this objective, evidence-based approach is mirrored in default interest analysis.
Courts look for concrete justification tied to the transaction, not generalised claims about deterrence or discipline.
Disproportion and Practical Outcomes
Finally, courts consider the practical effect of default interest over time. Even where a default rate is defensible at inception, its operation—particularly compounding—may produce outcomes that invite scrutiny.
In Guardian Mortgages Pty Ltd v Miller [2004] NSWSC 1236, the Court was confronted with a lending structure in which interest accumulated rapidly due to short-term compounding at a high monthly rate.
This kind of outcome frequently prompts courts to ask whether default interest has crossed from risk pricing into effective punishment.
Common Risks, Misconceptions, and Consequences
Australian courts have repeatedly demonstrated that claims for default interest fail not because default interest is impermissible in principle, but because parties misunderstand the doctrinal limits governing penalties, damages, and compensatory recovery.
The following risks and consequences emerge from the authorities.
Default Interest Is Automatically Enforceable
A recurring cautionary theme in the authorities is that default interest is not presumptively valid merely because it is expressly provided for in the contract.
Courts do not approach default interest as an ordinary incident of contractual enforcement.
Instead, where an increased rate is triggered by default, the clause is exposed to characterisation as a collateral stipulation and assessed under the penalty doctrine.
Parties who proceed on the assumption that default interest will be enforced unless it is extreme often fail to address the threshold question of character.
That failure can be fatal, particularly where the interest uplift is triggered solely by non-performance rather than forming part of a genuine alternative pricing structure.
Courts Can Moderate or Adjust Excessive Default Interest
Another common error is the belief that, if a default interest rate is found to be excessive, a court may simply reduce it to a reasonable level. Australian law does not permit that outcome.
The penalty doctrine operates on an all-or-nothing basis: once a stipulation is characterised as a penalty, it is unenforceable in its entirety.
This has significant practical consequences. A lender who overreaches in drafting or enforcement does not recover a lesser default rate as a matter of discretion.
Instead, the contractual entitlement falls away altogether, leaving the claimant confined to such damages or statutory interest as may otherwise be available.
Treating Default Interest as a Substitute for Proof of Loss
Default interest is sometimes pleaded as a proxy for loss, particularly where delay or non-payment has disrupted a lender’s funding or capital position. Courts have consistently rejected that approach where the clause itself is unenforceable.
If default interest fails, the claimant must revert to orthodox principles of causation and proof.
Loss must be shown to flow from the breach itself, not from subsequent enforcement decisions such as termination, acceleration, or realisation of security. Interest accrued because those choices may not be recoverable as damages.
This creates a practical litigation risk: where a default interest clause is struck down, claimants may find themselves unable to establish compensable loss at anything approaching the contractual default rate.
Conflating Penalty Analysis with Unconscionability or Fairness
Parties frequently attempt to reinforce penalty arguments by appealing to broader notions of unfairness, harshness, or imbalance. Courts have warned against collapsing distinct doctrines into a single evaluative exercise.
Penalty analysis is concerned with the character and proportionality of a stipulated consequence at the time of contracting.
It does not turn on whether the outcome appears unfair in hindsight. Unconscionability, statutory or equitable, involves different elements and a different inquiry.
Treating harshness as a proxy for invalidity risks misdirecting the court and weakening the credibility of the argument advanced.
Reversion to Damages or Statutory Interest Only
Where default interest is unenforceable, recovery is limited to what the law otherwise permits.
This will typically involve either statutory interest awarded in the court’s discretion or damages for loss of use of money, provided that loss is foreseeable, causally connected to the breach, and properly pleaded.
These remedies rarely replicate the economic effect of contractual default interest. Statutory rates are often materially lower, and damages claims impose a heavier evidentiary burden.
As a result, the commercial consequences of an invalid default interest clause can be substantial.
Practical Drafting and Litigation Implications
Courts assessing default interest clauses apply established penalty principles with close attention to structure, purpose, and proportionality.
The implications for drafting and litigation strategy are significant, particularly given the consequences of invalidity and the absence of any remedial discretion.
Drafting Default Interest Clauses
The starting point for drafting is that labels are not determinative. Courts examine substance rather than form, and will characterise a clause by reference to its operation and purpose at the time of contract formation.
In Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79, Lord Dunedin articulated the foundational principle that continues to inform modern drafting analysis, as stated at [1]:
Though the parties to a contract who use the words ‘penalty’ or ‘liquidated damages’ may prima facie be supposed to mean what they say, yet the expression used is not conclusive. The Court must find out whether the payment stipulated is in truth a penalty or liquidated damages.
For default interest, this means that describing a higher rate as “standard” or a lower rate as “concessional” will not avoid scrutiny if the higher rate is only engaged upon default.
Drafting must therefore ensure that the increased rate can plausibly be justified as part of the commercial allocation of risk, rather than as a sanction for non-performance.
Proportionality and Time of Assessment
A recurring drafting error is to focus on how a default interest rate might operate in practice, rather than whether it was proportionate when agreed. Courts assess proportionality as at contract formation, not with hindsight.
Again in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79, Lord Dunedin made clear that characterisation depends on the circumstances existing at the time the bargain was struck, as stated at [3]:
The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach.
For default interest clauses, this underscores the importance of contemporaneous justification. A rate that later produces an onerous outcome may nevertheless be enforceable if it was proportionate to the risks contemplated at inception.
Consequences of Invalid Default Interest
If a default interest clause is held unenforceable, recovery is confined to whatever remedies are otherwise available at law. This typically means statutory interest or damages for loss of use of money, subject to proof of causation and foreseeability.
The absence of any remedial discretion means that default interest clauses, if poorly structured, can materially undermine recovery rather than enhance it.
The practical lessons from the authorities are clear. Default interest clauses demand disciplined drafting, careful proportionality, and a clear commercial rationale.
Courts will not defer to labels, will not moderate penal provisions, and will not assess enforceability by reference to hindsight or fairness.
Parties who ignore these constraints expose themselves to significant and avoidable risk.
Key Takeaways – Default Interest Clauses
Australian courts assess claims for default interest through a structured and exacting analysis.
Default interest is not impermissible in principle, but its enforceability depends on characterisation, proportionality, and justification assessed at the time of contracting.
Courts focus on substance rather than labels, and the inquiry is doctrinal rather than discretionary.
As discussed, where a default interest clause is triggered by breach and imposes an additional burden, it is exposed to scrutiny under the penalty doctrine.
That scrutiny centres on whether the clause protects a legitimate commercial interest and whether the stipulated consequence is proportionate, judged at inception rather than by reference to later outcomes.
Statutory interest and compensatory damages operate as residual remedies where contractual default interest fails, but they do not validate penal clauses or permit courts to re-engineer the parties’ bargain. Overreaching provisions are not moderated; they are excluded.
The practical lessons show that many default interest claims falter due to mistaken assumptions about enforceability, judicial discretion, or fairness.
Drafting and litigation success depend on disciplined structure, evidentiary justification, and a clear appreciation of the limits of judicial intervention.
Parties who approach default interest with that discipline are materially better placed to manage both legal risk and commercial outcome.
Default Interest Clauses – FAQ
The following frequently asked questions address common issues that arise in relation to default interest clauses in commercial and lending agreements.
They summarise how Australian courts analyse enforceability, proportionality, and the consequences of invalidity under the penalty doctrine.
What is a default interest clause in a contract?
Default interest is a higher interest rate that applies when a borrower fails to meet a payment or other obligation under a contract. It is commonly used in loan, finance, and commercial agreements to address increased risk, delay, or administrative cost associated with default. Courts assess default interest by looking at how it operates in practice, not just how it is described in the contract.
Is default interest enforceable in Australia?
Default interest can be enforceable, but it is not automatically valid. Australian courts assess whether a default interest clause operates as a genuine part of the contractual bargain or as a penalty imposed upon breach. If the clause is found to be penal, it will be unenforceable. Enforceability depends on factors such as proportionality, purpose, and commercial justification.
When will a default interest clause be considered a penalty?
A default interest clause may be considered a penalty if it imposes an additional burden solely because of breach and is out of proportion to the legitimate interests it is said to protect. Courts examine whether the clause is punitive or deterrent in substance, rather than compensatory. The assessment is made by reference to the circumstances at the time the contract was formed.
Can courts reduce an excessive default interest rate?
No. Australian courts do not rewrite or adjust default interest clauses they consider excessive. If a default interest clause is characterised as a penalty, it is unenforceable in full. The court will not substitute a lower or “reasonable” rate. Instead, the claimant may be confined to statutory interest or damages, if otherwise available.
Does calling interest “standard” instead of “default” avoid penalties?
No. Courts look to the substance of the obligation, not the label used. Simply describing a higher rate as “standard” and a lower rate as “concessional” will not prevent scrutiny if the higher rate only applies upon default. What matters is how the interest operates and whether it is triggered by non-performance.
How do courts decide if default interest is proportionate?
Courts assess proportionality by considering whether the default interest rate is out of all proportion to the legitimate commercial interests it is said to protect. This includes examining risk, funding costs, delay, and administrative burden. Importantly, proportionality is assessed at the time the contract was entered into, not by reference to how much interest later accrues.
What happens if a default interest clause is unenforceable?
If a default interest clause is unenforceable, it is excluded entirely. The claimant cannot rely on it to recover interest at the default rate. Recovery may be limited to ordinary contractual interest accrued before default, statutory interest awarded by the court, or damages for loss of use of money, subject to proof and applicable legal principles.
Is default interest the same as statutory interest?
No. Default interest arises from contract, while statutory interest is awarded under legislation at the court’s discretion. Statutory interest may apply where contractual interest is unavailable or unenforceable, but it does not validate an invalid default interest clause. The two operate independently and serve different purposes.
Do courts consider hardship or unfairness when assessing default interest?
Hardship or unfairness alone does not determine enforceability. Courts do not invalidate default interest clauses simply because they produce harsh outcomes. The focus is on legal characterisation, proportionality, and legitimate interest, not on hindsight assessments of fairness. Separate doctrines, such as unconscionability, involve different tests and considerations.
What are common mistakes when relying on default interest clauses?
Common mistakes include assuming default interest is automatically enforceable, expecting courts to reduce excessive rates, failing to justify the rate commercially, and relying on severity of outcome rather than proper legal characterisation. These errors can result in complete loss of the default interest entitlement, leaving parties confined to more limited remedies.
