Default Interest Rates Explained: The Penalty That Can Sink Your Scheme

Default interest is an enhanced rate of interest that the lender is entitled to charge when the borrower is in breach of the facility agreement. The default rate is specified in the loan documentation and is typically expressed as the standard interest rate plus a margin of 3% to 8% per annum. If your standard rate is 8% and the default margin is 5%, the default rate is 13% per annum. This represents a dramatic increase in borrowing costs that can quickly erode your project's profit margin.

Default interest is triggered by an event of default, which is defined in the facility agreement. The most common trigger is failure to repay the loan on the maturity date, but events of default can also include: breach of a loan covenant (such as a loan-to-value ratio breach), failure to maintain required insurance, failure to provide information requested by the lender, material adverse change in the borrower's financial position, and failure to comply with planning conditions. The breadth of these triggers means that default interest can apply in circumstances that the borrower did not anticipate.

It is critical to understand that default interest is not just a theoretical risk. In our experience, approximately 10% to 15% of development finance facilities enter some form of default during their term, whether due to programme overruns, covenant breaches, or administrative failings. The financial consequences can be severe, which is why understanding the default provisions in your facility agreement is essential before you commit.

Default interest is calculated on the full outstanding balance of the facility from the date the event of default occurs until the date it is remedied or the loan is repaid. The calculation is straightforward but the impact is substantial. On a facility of £2,500,000 with £2,000,000 outstanding, a default rate of 13% per annum equates to £260,000 per year or approximately £21,667 per month. Compare this to the standard rate of, say, 8%, which would generate £160,000 per year or £13,333 per month. The additional cost of default is £8,333 per month, or approximately £100,000 per year.

Some lenders apply default interest retrospectively, meaning it is calculated from the original drawdown date rather than the date the default occurred. This is particularly punitive because it can generate tens of thousands of pounds in additional interest charges overnight. We have seen retrospective default interest clauses add £30,000 to £50,000 to a borrower's liabilities on facilities where the default occurred near the end of the term. Always check whether the default interest clause in your facility agreement is prospective (from the date of default) or retrospective (from drawdown), and factor this into your risk assessment.

Default interest is typically compounded, meaning that interest accrues on the unpaid default interest itself. On a facility in default for several months, the compounding effect can be significant. A £2,000,000 balance at a 13% default rate, compounded monthly, generates approximately £22,000 in the first month, but by month six the monthly charge has grown because interest is accruing on the accumulated default interest. Over six months of default, the total additional interest charge could be £135,000 to £140,000 rather than the £120,000 you might expect from a simple interest calculation.

The most frequent trigger for default interest in development finance is failure to repay the loan at maturity. If your project takes longer than expected and you need more time to sell units or refinance, the lender may treat the maturity date breach as an event of default and apply the enhanced rate. This is distinct from a formal extension, which is an agreed continuation of the facility at modified terms. If no extension is agreed and the loan runs past its maturity date, default interest typically applies automatically.

Loan-to-value covenant breaches are another common trigger. If the lender requires the loan-to-value ratio to remain below 65% and a fall in property values pushes the ratio above this threshold, the lender may declare an event of default. This can happen even if the borrower is making timely payments and the construction is on schedule. Market movements are outside the borrower's control, but the covenant breach is the borrower's problem. Some lenders will allow a cure period, typically 14 to 30 days, during which you can remedy the breach by injecting additional equity, but the default interest may still accrue during this period.

Administrative defaults are often overlooked but can be equally costly. If the lender requires you to provide updated insurance certificates by a specific date and you fail to do so, this can technically constitute an event of default. Similarly, failure to provide quarterly management accounts, notification of contractor changes, or evidence that planning conditions have been discharged can all trigger default provisions. These administrative requirements are set out in the facility agreement and must be monitored carefully throughout the loan term. We advise all our clients to create a compliance calendar that tracks every obligation and deadline in the facility agreement.

Default interest provisions are among the most difficult terms to negotiate in a development finance facility agreement, because lenders view them as an essential protection against borrower risk. However, there are several aspects that can be influenced at the term sheet stage. First, negotiate the default margin down. If the lender's standard default margin is 6%, ask for 3% or 4%. The lower margin still provides the lender with a meaningful penalty but reduces the financial impact on the borrower if default occurs.

Second, ensure that the default interest clause includes a cure period before default interest begins to accrue. A 14-day cure period gives you time to remedy administrative breaches without incurring penalty interest. Without a cure period, default interest can apply from the moment a breach occurs, even if the breach is inadvertent and easily remedied. We have seen borrowers pay £5,000 to £10,000 in default interest because an insurance renewal notice was delayed by a week, which is a disproportionate penalty for an administrative oversight.

Third, negotiate for prospective rather than retrospective application of default interest. As we discussed, retrospective application calculates default interest from the original drawdown date, which can generate enormous additional charges. Prospective application, from the date of default, is more proportionate and is the standard approach among the more borrower-friendly lenders on our panel. If a lender insists on retrospective default interest, consider whether their other terms are sufficiently attractive to justify this risk. Submit your project through our deal room and we will ensure that default interest provisions are included in our negotiation on your behalf.

The most effective way to avoid default interest is to avoid default, which means careful project management and proactive communication with your lender. Maintain a realistic build programme with appropriate contingency, use experienced contractors, and ensure your project manager is tracking progress against the programme at all times. If slippage occurs, address it early rather than hoping to catch up later.

Build a relationship with your lender's relationship manager and the monitoring surveyor. Regular, transparent communication about project progress builds trust and makes it easier to discuss challenges when they arise. A lender who trusts the borrower and has confidence in the project is far more likely to offer a reasonable extension than to enforce default provisions. Conversely, a lender who feels that the borrower has been evasive or non-communicative is more likely to take a hard line.

Keep impeccable records. Every communication with the lender, every insurance renewal, every planning condition discharge, and every monitoring surveyor report should be filed and accessible. If a dispute arises about whether an event of default has occurred, clear documentation is your best defence. We also recommend appointing a compliance officer within your development team, even if it is a shared responsibility, to ensure that all obligations under the facility agreement are met on time. The cost of this administrative discipline is trivial compared to the financial consequences of an inadvertent default on a facility secured against a development worth £3,000,000 or more.

Under English law, a default interest provision that constitutes a penalty may be unenforceable. The legal test, established in the landmark case of Cavendish Square Holding BV v Makdessi, is whether the provision is a proportionate means of protecting the lender's legitimate interest. If the default rate is so high that it amounts to a punishment rather than a genuine pre-estimate of the lender's loss, a court may refuse to enforce it.

In practice, default margins of 3% to 5% above the standard rate are generally considered enforceable because they reflect the lender's increased risk and cost of managing a defaulted facility. However, default margins of 8% or above may be challenged, particularly if the lender cannot demonstrate a commercial rationale for the level of penalty. We are aware of cases where borrowers have successfully challenged default interest provisions on development finance facilities, resulting in the default margin being reduced or the default interest being waived entirely.

If you find yourself in a situation where default interest has been applied and you believe the charge is disproportionate, seek legal advice promptly. Do not assume that the lender's position is unassailable. At the same time, do not rely on the courts as your primary protection; the cost and uncertainty of litigation makes it a last resort. The best approach is to negotiate fair default provisions at the outset, maintain open communication with the lender, and manage your project diligently to avoid triggering default in the first place. For further guidance on structuring your facility to minimise risk, speak to us through our deal room or review our guide on how development finance works.