An appealing offer from a regional bank with affordable monthly payments persuaded the Robinsons to restructure their mortgage. The bank representative was quite smooth in his delivery, however he failed to indicate the loan’s balloon payment was due in five years.
Unprepared, the Robinsons were forced to accept the lender’s offer to refinance their loan—this time at a higher interest rate and with extra fees and closing expenses. They didn’t come out ahead, but were instead saddled with unmanageable debt obligations.
The fictional Robinsons’ story nonetheless stands for the serious and pervasive problem of predatory lending. This term encompasses a wide range of dishonest (and frequently illegal) lending practices that put lenders ahead of borrowers. Predatory lenders take advantage of borrowers’ lack of financial literacy by providing them with misleading information and pressuring them to take out loans they cannot afford.
What Is Predatory Lending?
It’s important to distinguish between predatory lending and mortgage relief scams. Swindlers in mortgage relief scams promise to help their victims get out of their mortgage payments but end up keeping the money instead. Loans that predatory lenders provide are legitimate, but often come with stipulations that are difficult for the borrower to satisfy.
Payday loans are often regarded as the most exploitative of all lending forms. Loans like this are extremely challenging to repay because of their exorbitant interest rates and limited payback periods.
However, in most situations, it is not certain items but rather particular habits that constitute predatory behavior. As an example, ARMs, or adjustable-rate mortgages, are a legitimate kind of credit that certain borrowers may find helpful. Bait and switch refers to the practice of predatory lending where a lender gives you an ARM without indicating that your interest rate will increase after the introductory period. It’s not the loans themselves that are predatory, but the dishonesty involved.
Lending Practices That Are Predatory
Predatory lending encompasses a wide variety of behaviors. One thing that they all have in common, however, is that they set borrowers up for failure by convincing them to take out loans that are beyond their means. Some examples of predatory lending are:
- Capitalization on Assets. Lenders typically consider your monthly income when deciding how much of a loan they should provide you. A predatory lender, on the other hand, can offer you a larger loan based on the value of your assets, such as your home. There is a danger of defaulting and losing your property to foreclosure because the payments are too high. Equity stripping is another term for this scheme.
- Misleading actions with ulterior motives. In a bait and switch, the lender advertises one sort of loan but provides another. A lender, for instance, might decide to drastically increase your interest rate several payments or years into the loan, making it impossible to repay. Inadequate disclosure, such as “bait and switch,” occurs when a borrower is not given complete information about the loan’s real cost, risk, or conditions.
- Inflatable Benefits. A balloon loan is a type of loan with initially low installments followed by a large payment for the remaining debt. It’s not always the case that a lender that offers a balloon loan is being predatory if they take the time to explain the terms of the loan and the potential consequences to the borrower. On the other hand, predatory lending describes any loan that includes a balloon payment that isn’t disclosed until closing.
- Turnover in a loan. Financial institutions may repeatedly suggest that borrowers refinance their loans. There will be additional charges added to your bill with each new instance. The lender ensures that each new loan is just as unaffordable as the prior one in order to trap you in a perpetual cycle of refinancing. To a large extent, this is how payday loans always work.
- Putting together a loan. It’s possible to get “stuffed” with fees for a variety of other services that you didn’t ask for or require when you take out certain loans. Credit insurance is the most popular add-on, as it would repay the debt in the case of your untimely demise. Predatory lenders may frequently make you believe that you need credit insurance in order to get a loan, whereas in fact there is nothing illegal about giving credit insurance as part of a loan agreement. There is no truth to either of these assertions.
- The Amortization Expense Was Negative. Interest-only payments on some of the most expensive mortgages can be quite costly. When you make minimum payments, all of your money goes toward interest rather than reducing the main balance, so your debt never goes down. Further, with negative amortization loans: You can’t even pay off the interest with your monthly installments. Paying off debt takes time since interest is compounded every time you pay.
- Costs for early payments. You may be charged a prepayment penalty if you pay off your mortgage or auto loan before its scheduled maturity date. Lenders impose this fee because they stand to lose interest income if you make a prepayment. In most cases, prepayment penalties are the lesser of six months’ worth of interest or 2% of the principal sum. Predatory lenders, on the other hand, typically impose substantially stiffer prepayment penalties in an effort to prevent borrowers from switching to a new loan with more favorable conditions.
- Blacklisting in reverse. By “redlining,” we imply discriminating against people because of their race or socioeconomic status by not providing them with credit or insurance. The Chicago Tribune revealed in 2018 that numerous financial institutions continue to engage in this practice despite the fact that it is now banned.
Unfortunately, there are unscrupulous lenders out there that actively seek out low-income communities to promote their services. The residents of these areas, even those with excellent credit and access to cheaper rates elsewhere, are subjected to these inflated premiums.
- Prices that take risks into account. Poor credit customers pay higher interest rates from every lender. Since borrowers with poor credit histories are more likely to stop making loan payments, this is a necessary precaution. But unscrupulous lenders take this to an extreme. They seek out the riskiest borrowers, the ones most banks wouldn’t touch, and charge them over the roof.
Victims of Predatory Lending
Despite the fact that predatory lending may harm anybody, there are some populations that are more likely to be specifically targeted by loan sharks. Those things are:
- Borrowers who are considered a “subprime” risk. Borrowers in the subprime market often have credit scores below 630 and salaries below the average for the industry. Predatory lenders, as mentioned above, target such borrowers specifically to extract as much profit as possible through exorbitant interest rates.
- Poor Families. Even with solid credit, low-income households typically pay higher interest rates on loans. When these borrowers might otherwise be eligible for a good loan, practices like reverse redlining may drive them into predatory loans instead. Payday loans, auto title loans, and bank overdraft fees are all examples of predatory lending practices that are disproportionately used by low-income borrowers, according to a report published by the Center for Responsible Lending (CRL) in 2015. Additionally, low-income families are disproportionately represented among those who send their children to for-profit universities, which leads to higher levels of debt and fewer employment options for those who graduate.
- Individuals of color. In general, loans for people of color carry higher interest rates than loans for those of white race who have similar credit histories. The CRL analysis found that persons of color spend an average of 0.2% to 0.3% more in interest on vehicle loans and are more than three times as likely to acquire high-cost home loans. African Americans have a much higher propensity to use payday loans and attend for-profit universities than whites.
- Individuals of Retired Age. The elderly homeowner market is a popular one for predatory mortgage lenders. The limited incomes of these homeowners sometimes fall short of covering unexpected costs like major maintenance or medical bills. According to a fact sheet published by the National Consumer Law Center, lenders often coax the elderly into taking out loans against their homes in order to meet their financial obligations, only to charge them exorbitant interest rates and present them with unfavorable repayment terms.
- Members of the Armed Forces. Members of the military are a common target for predatory lenders. Because of their young age and low credit scores, military personnel have fewer borrowing possibilities than civilians. Those older military members with families who have to cope with frequent deployments and moves have a tough time making ends meet. According to a study published by the Department of Defense in 2006, predatory lenders often set up shop near military bases and advertise actively to service personnel, who are often financially strapped.
- Members of the Public in a Financial Emergency. Finally, predatory lenders frequently target those who need quick access to cash due to an unexpected expense. It might be the loss of a job, the need for expensive repairs to one’s house, or an unexpected medical emergency.
In order to attract new customers, loan sharks employ a wide range of tactics. They prefer to target areas with high concentrations of the poor, minorities, and the elderly. They flood these communities with advertisements across all mediums, from television and radio to direct mail and cold calling, all touting the cheap monthly payments and high interest rates of their loans. Advertisements in Spanish or another language spoken locally are a popular tactic used to woo minority borrowers.
Why predatory lending is detrimental
Harmful effects from predatory lending practices extend beyond the individuals targeted. Some of the major issues with these loans are highlighted in the CRL report.
- Extremely High Rates of Default. When borrowers are treated abusively, it often results in a loan default, repossessed property, or a foreclosure. As an example, borrowers who obtain auto loans from car lots, who are notorious for their predatory lending tactics, are twice as likely to have their vehicles repossessed as those who obtained similar financing through a bank or credit union.
- Reduced credit scores. If you fail on a predatory loan, you might end up with a severely damaged credit score for years to come. They may end up paying more for future loans and may have trouble renting an apartment or securing insurance. About one in seven people who apply for a job and have poor credit are rejected due to the results of a credit check.
- Risky financial situations. Borrowers are likely to be trapped in a never-ending cycle of debt if they take out even one abusive loan and then need to take out another loan just to get by. The burden of debt might also restrict their access to other forms of credit. Borrowers who have difficulty repaying payday loans, for instance, frequently find themselves in the position of having to withdraw funds from an ATM. If this keeps happening, they may lose access to their bank account and be forced to use more expensive “fringe financial products,” such check-cashing services.
- Misplaced Houses. If you lose your house to foreclosure, it may be a devastating experience on many levels. You won’t be able to take advantage of the home-equity-building process, and you’ll be under even more pressure to relocate quickly. According to the CRL analysis, the average household who lost their home during the subprime mortgage crisis lost almost $18,000 in wealth. Some people may be homeless after losing their homes to foreclosure.
- Real estate values are declining. Community as a whole suffers when homeowners go through foreclosure. When one house in a neighborhood goes into foreclosure, it brings down the value of all the other homes in the area. Foreclosure hotspots tend to be low-income and minority communities, where the average property value drops by around $23,150.
- Disorganized Groups of People. When this $23,150 in lost income is multiplied by the number of properties in a community, a significant amount of money is being siphoned out. There will be less money for things like strong schools, local businesses, and community resources, all of which are essential to a thriving community. That’s why predatory lending may hasten the decline of poor communities.
- The Economic Fallout. Approximately 8.4 million jobs and almost $10 trillion in economic production were lost in the United States during the Great Recession, which was caused by subprime mortgage lending. There is now evidence that student loan debt is limiting economic development, especially among young families.
- Inequality has grown. The poor are the primary recipients of predatory loans, while the wealthy who own shares in major banks benefit from this system in a manner akin to a reverse Robin Hood. The already-existing problem of wealth and income disparity is exacerbated by these loans. A widening divide between the wealthy and everyone else, particularly between whites and minorities, is bad for everyone in the country. Studies in happiness economics have indicated that people in countries with more inequality are usually unhappier than people in countries with lower inequality, and a 2015 research from the International Monetary Fund (IMF) concluded that higher income disparity in a country might hinder economic development.
- Loss for the Banking Industry. For banks that engage in predatory lending, the repercussions extend beyond the borrowers they harm. Banks with exploitative credit card practices routinely lost more money than other banks did during the past recession, according to CRL’s research. To be sure, unscrupulous lenders often bear the brunt of the consequences. Predatory lending can cause borrowers to fall behind on payments or default on other debts because they simply can’t afford to pay what they owe. What’s more, the public loses faith in the financial system as a whole as they become more aware of predatory lending and its consequences. Since they have less trust in banks, they are less likely to use financial services and are instead inclined to use cash.
Predatory Loans and How to Avoid Them
The foregoing rules have made it more difficult for lenders to engage in predatory practices, but they have not eliminated them. Numerous loan companies either skirt the law or actively breach it. For instance, the ECOA makes it illegal to engage in reverse redlining, although this practice persists even now.
More importantly, Trump appointees at the Consumer Financial Protection Bureau (CFPB) are chipping away at several consumer protection regulations. For instance, the CFPB conducted frequent checks on military lenders to ensure they abided by the MLA until very recently.
However, the CFPB said in August 2018 that it would no longer conduct these regular checks and instead focus on lenders that had received legitimate complaints.
A month later, attorneys general from 14 different states protested the CFPB’s decision to no longer enforce the ECOA. And the new director of the Consumer Financial Protection Bureau, Kathy Kraninger, was reportedly taking action in February 2019 to reverse Obama-era restrictions on payday loans, as reported by The Hill.
The moral of the story is that you need to take issues into your own hands to safeguard yourself from predatory loans. Knowing the warning signs of a predatory loan, borrowing money with prudence, and knowing your options are all part of being financially literate.
How to Safeguard Yourself
You may easily locate a trustworthy lender by turning the aforementioned red flags around. A reliable lender will look at your credit history and won’t give you more money than you can afford to pay back.
It will be completely transparent about all fees, will aid you in comprehending the nuances of your loan, and will not exert any undue pressure. There won’t be many problems reported by customers either.
Even when dealing with a reputable lender, it pays to proceed with caution and review all paperwork thoroughly. A few things to bear in mind are as follows.
- Determine Your Financial Limits. Figure out how much debt you can afford to bear before you start looking for loans. Your debt-to-income ratio (DTI) can be calculated by subtracting your monthly payment on debt from your gross monthly income. Your new loan shouldn’t increase your DTI by more than 36 percent.
- Don’t buy the first thing you see. Get bids from at least three different lenders and shop for a loan the same way you would for a house contractor. Verify that each potential lender carries the appropriate licensing.
- Solicit Detailed Information by Posing Numerous Questions. As soon as you’ve decided on a lender to work with, it’s time to get familiar with the fine print. Inquire about the prepayment penalty, whether or not your payments will fluctuate over the course of the loan’s duration, and whether or not your payments will cover things like taxes and insurance. You should research whether or not your loan offers a cancelation period of three days. Dispute any extra charges that don’t make sense.
- Relax and take your time. Don’t be pressured into signing anything or giving up any of your rights by the lender. You should acquire your home loan settlement statement three days before closing and study it carefully.
- Look out for the Warning Signs. Even if you’re close to closing, you shouldn’t sign any blank contracts or waivers of rights that the lender provides you. It is preferable to start again than to be stuck with predatory debt for a long period of time.
You may take several steps on your own to safeguard yourself from predatory lending practices. You may get out of a predatory loan through a variety of methods, and you can prepare yourself to spot and avoid them.
However, it is considerably more difficult to halt the harm that predatory lenders cause to our economy and society. The most effective strategy for this is to enact stricter legal safeguards for borrowers and to increase the enforcement of existing regulations. Unfortunately, the government appears to be taking the opposite approach right now by weakening and eventually eliminating current safeguards.
To counteract this, citizens must stop thinking and acting like consumers. If you keep up with the news and learn of a bill that will affect consumers in a positive or negative way, I encourage you to contact your congressional representatives. In the upcoming election, remember to consider the candidates’ stances on consumer problems while casting your ballot.