When does a steep default interest rate become an unenforceable penalty? That was the question in Houssein v London Credit Ltd - a case that offers important guidance on when a default interest clause becomes a penalty and how courts assess a default interest clause penalty in commercial lending.

Background: How the Default Interest Clause Became a Penalty Issue

London Credit, a prominent lender in the short-term property finance market, lent £1.88 million to CEK Investments, secured against five buy-to-let properties and the family home.

The deal looked straightforward:1% monthly interest. But if the borrower defaulted, the rate jumped to 4%, compounded monthly - a classic example of a default interest clause that could be challenged as a penalty interest clause.

There was also a condition: no directors or close family members could live in the home. The borrowers breached the condition and missed the repayment date, prompting London Credit to apply the higher default rate.

The borrowers argued that the 4% default interest clause was an unenforceable penalty. In their view, the rate was punitive, not compensatory, and far exceeded any real loss London Credit might suffer. They asked the court to strike down the default interest clause penalty and reduce what they owed.

The Trial: Was the Default Interest Clause a Penalty?

The first judge agreed with the borrowers, ruling that the 4% default rate was a penalty interest clause - too harsh and not compensatory.

Unsurprisingly, London Credit Ltd wasn’t happy with that outcome. They appealed to the Court of Appeal, arguing that the judge had misapplied the legal test for penalties set out in Cavendish Square Holding BV v Makdessi.

The Cavendish/Makdessi Test for Default Interest Clause Penalty Disputes

The right question when determining whether a default interest clause penalty or rate is unenforceable isn’t:
“Is this a punishment?”
The correct question is:
“Does this clause protect a legitimate interest, and is it proportionate?”

This legal test was set out by the Supreme Court in Cavendish Square Holding BV v Makdessi [2015] UKSC 67 (decided alongside ParkingEye Ltd v Beavis).

Before Cavendish, the rule was, on its face, clear-cut: if a clause imposed a sum that was “extravagant and unconscionable” compared to the actual loss, it was a penalty and unenforceable.

Cavendish introduced a structured approach:

1. Is the clause triggered by a breach?
   Penalty rules only apply if the clause is triggered by breach. If the default interest clause forms part of the primary obligations, the penalty rule doesn’t apply.
2. Does the clause protect a real business interest?
   The court looks at why the default interest clause exists. Is it just punishing the other party, or does it protect something important - like credit risk, timely payment, or security?
3. Is the clause way over the top?
   Even if there’s a good reason for the default interest clause, the court checks whether the amount or effect is completely out of proportion to that reason. If it’s “exorbitant or unconscionable,” it won’t stand.

The Court stressed in Makdessi that freedom of contract matters -especially in commercial deals between sophisticated parties. A clause isn’t unenforceable merely because it is harsh; it must be penal in nature rather than protective.

The Court of Appeal’s View on the Default Interest Clause Penalty Issue

In Houssein, the Court of Appeal agreed with the lender, finding that the original High Court decision didn’t correctly apply the Cavendish test.

After the Court of Appeal overturned parts of the first judgment, the case went back to the High Court for a further fact‑finding hearing.

The Rehearing: Applying the Default Interest Clause Penalty Test

At the rehearing in 2025, the High Court applied the Cavendish/Makdessi test properly. The judge didn’t just look at the numbers. He examined why the lender had included such a steep default interest clause penalty.

London Credit was able to show five legitimate commercial interests behind the 4% rate:

• Timely repayment – Late payments disrupt cash flow and increase risk.
• Protecting security – The lender needed to safeguard the value of the properties securing the loan.
• Managing credit risk – Higher rates help offset the additional risk when a borrower defaults.
• Regulatory concerns – Compliance obligations can be affected by defaults, so lenders need strong deterrents.
• Avoiding collateral dilution – If the borrower’s position weakens, the lender’s security could lose value.

The judge accepted that these were real and important interests. While 4% per month was undeniably high, it wasn’t “out of all proportion” to those interests. In other words, the default interest clause wasn’t just a punishment - it served a legitimate purpose.

The result? The default interest clause was enforceable.

Why This Decision Matters

This decision provides an important reminder for all parties engaged in commercial lending, whether as lender or borrower. It reinforces that:

• A default interest clauses is not an automatic penalty - they can be enforceable if they serve a legitimate purpose and are proportionate.
• Courts will look beyond the numbers to the commercial context.
• For lenders, it’s a reminder to document the reasons behind steep default rates.
• Borrowers should be aware that a penalty argument may not succeed if the lender can show legitimate interests.

For another example of the courts assessing whether a default interest provision is a penalty, see my analysis of Ahuja Investments Ltd v Victorygame Ltd. In this case, the court held that a 12% monthly default rate was an unenforceable penalty.

Legal disclaimer

This article provides general information only and does not constitute legal advice. It is not a full or definitive statement of the law in England and Wales.

Although I aim for accuracy, I give no warranty as to the information provided and accept no liability for any errors or omissions.

Always seek specialist advice before relying on the contents of this article.

© Melissa Worth, January 2026