Understanding Default Interest Clauses
A couple of recent re-financing cases have reminded me of how important it is that legal clauses in loan agreements are understood by everyone where possible.
One such clause that can need explaining is the default interest rate clause, which for many developers (and their selected lawyers if they lack development loan agreement experience), comes as a shock when they see that lenders reserve the right to charge default interest at often 3% or 4% per month!
(At this stage please note that I’m not a lawyer, these are my thoughts from experience, and do seek independent advice if you need it.)
Why is there a Default Interest Clause?
The clause is there to act as an incentive to the borrower to form a strong working relationship with the lender. Any development finance lender will tell you that if the borrower communicates well then the lender will typically be accommodating to issues and do their level best to work with them, not against them.
The Lender’s Position
It’s key to remember that the lender wants to help you through any issues. This is because actually defaulting a project is a costly exercise that requires resource at the lender’s end to complete.
Selling a half-completed development on the Open Market for most lenders is a non-starter as the value clearly plummets and recovering full capital and interest is unlikely. Equally, re-financing to another lender is usually off limits too as any incoming lender has had no prior approved QS oversight. Most development finance lenders will not take over a project from another lender half way through. So the existing lender, at cost, will finish the development themselves. So it is in everyone’s interest to work well together.
What lenders don’t want to see is a total breakdown in communication and thus the relationship. If a borrower has a major problem and becomes unreachable, a lender is not going to view this well. It is at this point that a borrower runs the risk of default interest being applied.
Most lenders will say project defaults are very rare. It takes a lot to get to that point, and I personally have seen lenders offer more time, or if possible, further funding to help get the project built. A good current example is many developers, experiencing slow sales, are getting rolling facility extensions.
If you do end up in Court
Sadly there are rare instances where projects go wrong, people fall out and end up in court. My understanding of default interest is the actual payment of any has been tested legally at a much lower level than stated in most loan agreements. So whilst you may be able to challenge a high default interest rate and end up paying less, you will probably still have to pay something and there are legal costs, the emotional strain and lost time to consider along the way too. As always, it's the lawyers that usually win and the point of the clause is to incentivise everyone to stay out of court!
So the best way to look at a lender is like a JV partner, and one that you want to build a strong working relationship with. Due to the rolled up interest model, it is only when properties are being sold that either the lender or the developer starts seeing a return. If you view them as a partner that you are going to communicate well with, then you are highly unlikely to have to worry about going to court and paying default interest.
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