Lenders beware - when a high interest rate may be void as a penalty

Lenders rely on interest rates to cover the cost of lending to customers. This includes scenarios when the loan is for a short term period. However, there are circumstances when use of a high interest rate on default will be found to be void as a penalty.

The law against penalties focusses on whether the relevant provision in a contract operates as a genuine pre-estimate of loss or as a punishment for breach. If an interest clause, for example, stipulates payment of a sum that is extravagant, unconscionable, or out of all proportion to the loss likely to be suffered, it may be characterised as a penalty and found to be unenforceable. The party asserting a clause is a penalty, bears the onus of proving it but that onus will shift to the lender where the difference in the standard and default rate is disproportionate enough.

Blackbird singing in the dead of night

The case of Blackbird First Mortgage Corporation Pty Ltd v Cam Engineering & Construction Pty Ltd [2026] NSWSC 876 is a reminder of the principles behind the law against penalties when it comes to default interest provisions.

The facts

In late 2023, Blackbird advanced money to Cam Engineering to refinance an earlier loan advanced by another lender that was now in default. The loan by Blackbird was documented by a Deed of Secured Loan, a General Security Agreement, personal guarantees and a registered mortgage over a director’s home. The money advanced was $290,148.47 and was repayable 6 months from first drawdown.

The interest provision was for 2% per calendar month (24% per annum) which increased to 4% per calendar month (48% per annum) on default, compounding monthly. Interest was paid by the borrower at the standard rate until August 2024, after which receivers appointed by Blackbird issued demand for payment, served a default notice under the Real Property Act 1900 (NSW) and recovered some monies. The dispute that ensued was around the amount due.

What the court decided on the question of default interest

Muston J reviewed the evidence and found as follows on the default interest question:

• The shift from 24% per annum to 48% per annum (or 60% per annum when the compounding of unpaid interest is brought to account), is not a “small rateable increase”;

• The increase in the interest rate on default was sufficiently disproportionate to the loss that might ordinarily be expected to be suffered by a lender for the onus of explaining the basis for that increase to have shifted to Blackbird;

• The defendants were always obligated to indemnify Blackbird for a wide range of expenses which it might incur in the event of any default and Blackbird’s potential exposure to such expenses in the event of a default provides no real explanation for any increase in the interest payable by the defendants in such circumstances;

• While it is accepted that on default potentially the defendants represented a worse credit risk for the lender but that can only be taken so far

• In the absence of any other explanation, the only real purpose for the doubling of what was already a substantial interest rate on default was to deter non-compliance with the terms of the loan

• The fact that another lender at the time was proposing to charge an equivalent rate of interest in the event of a default under its loan proposal does not alter the court’s view on this

• While the introduction of the default interest rate is considered to be a penalty, there is nothing inherently penal about that portion of cl 4.3 of the loan agreement which provides for the compounding of interest on a monthly basis

• If the obligation to pay interest at the default interest rate was unenforceable as a penalty, the defendants’ obligation to pay simple interest at the non-default interest rate continued.

Rather than voiding the whole default interest clause, the Court used the contract’s own severability clause to remove the sentence imposing the 4% default rate.

Key takeaways 

• keep record that account for and justify costs and fees payable by the borrowe

• if the default interest rate represents a material increase, ensure that you can justify it with evidenc

• include severability clauses that allow offending provisions to be sever rather than risk whole clauses failing

If you need assistance with any finance matter, do not hesitate to contact our Finance team.

Author: Rebecca Hegarty

This publication is intended as a source of information only. No reader should act on any matter without first obtaining professional advice.