When the Robinsons decided to refinance their mortgage, a local bank offered them a tempting deal with low payments they could easily afford. However, the smooth-talking bank representative glossed over the fact that the loan included a balloon payment that would come due in five years. When it hit, the Robinsons couldn’t afford to pay it, so their lender offered to refinance their loan yet again – but with a higher interest rate, higher fees, and, of course, a whole new set of closing costs. Instead of freeing up money in their budget, they ended up with payments they could barely meet.
Although the Robinsons’ story is fictional, it illustrates a very real and serious problem: predatory lending. This term refers to a wide range of unscrupulous – and, in some cases, downright illegal – loan practices that enrich lenders by squeezing borrowers. Predatory lenders mislead and manipulate borrowers, often taking advantage of their lack of financial savvy to steer them into loans they can’t afford.
What Is Predatory Lending?
Predatory lending is not the same thing as a mortgage relief scam. In mortgage relief scams, con artists offer to get victims out of an unaffordable mortgage, but instead take their money and run. Predatory loans are real loans, but with terms that are hard for borrowers to meet.
A few types of loans, most notably payday loans, are predatory by nature. Their high interest rates and short repayment terms make them difficult for anyone to pay back.
But in most cases, it’s not specific products that are predatory, but specific practices. For instance, adjustable-rate mortgages, or ARMs, are a perfectly valid financial tool that can be useful for certain types of borrowers. But if a lender sells you an ARM without disclosing the fact that your interest rate will go up after the initial period, that’s a type of predatory lending known as bait and switch. It’s the deception that makes it predatory, not the type of loan.
Predatory Lending Practices
There’s a wide range of practices that fall under the heading of predatory lending. However, they all have one thing in common: They trick or trap borrowers into loans they don’t really understand and can’t afford.
Specific predatory lending practices include:
- Asset-Based Lending. Normally, when you borrow money, the lender looks at your income to figure out how big of a loan you can handle. However, a predatory lender might offer you a larger loan on the strength of your assets, such as the equity in your home. Because the payments are more than you can afford, there’s a risk that you’ll default and lose your home to foreclosure. This practice is also known as equity stripping.
- Bait and Switch. When a lender promises you one type of loan but gives you a different one, this is called a bait and switch. For instance, a lender might suddenly jack up the interest rate to unaffordable levels months or even years into your loan. A bait and switch is a type of inadequate disclosure: failing to tell you the true cost, risk, or terms of your loan.
- Balloon Payments. A balloon loan is one where the payments start low, but then you get hit with one big payment for the entire remaining balance. Balloon loans aren’t always predatory; as long as the lender clearly explains how the loan works and discusses its risks up front, they can be legitimate. However, any loan with a hidden balloon payment – one the lender doesn’t tell you about until just before you close on the loan – is predatory.
- Loan Flipping. Sometimes, lenders will encourage you to keep refinancing your loan over and over again. Each time you do, they get to collect a fresh set of fees. To force you to keep refinancing, the lender makes sure that each new loan will be just as unaffordable as the last one. This is a standard practice in payday lending.
- Loan Packing. Some loans come “packed” with charges for a bunch of extra services you didn’t ask for and don’t need. The most common add-on is credit insurance, which pays off the loan in the event of your death. There’s nothing wrong with offering credit insurance as part of a loan deal, but predatory lenders often lead you to think that the law requires it, or that you won’t qualify for the loan without it. Both of these claims are false.
- Negative Amortization. Some of the priciest home loans start with interest-only payments. Each payment is just enough to cover the interest, with none of it going toward the principal, so your debt never gets smaller. Negative amortization loans go even further: The payments you make on them aren’t even enough to cover the interest. Each time you make a payment, the unpaid interest gets added to your total balance, so you get steadily deeper in debt over time.
- Prepayment Penalties. It’s not unusual for a home or car loan to come with a prepayment penalty, a fee for paying off your loan before its due date. Lenders include this penalty to discourage you from paying early since they get less interest that way. A typical prepayment penalty could be 2% of the total balance or six months’ worth of interest payments. However, predatory lenders often charge much higher prepayment penalties to discourage borrowers from refinancing into a new loan with lower interest or better payment terms.
- Reverse Redlining. The term “redlining” means refusing to offer financial products, such as mortgages or insurance, to anyone who lives in a low-income or minority neighborhood. Today, this practice is illegal, although the Chicago Tribune reported in 2018 that many banks still do it. However, some predatory lenders do precisely the opposite: They deliberately push their services in low-income neighborhoods that other banks avoid. They then charge extra-high rates to everyone in these neighborhoods, even people with good credit who could easily get a better deal.
- Risk-Based Pricing. All lenders charge higher interest rates to borrowers with poor credit. They have to do this to protect themselves since people with low credit are more likely to default on a loan. However, predatory lenders take this practice to extremes. They deliberately go after the highest-risk borrowers – people many banks wouldn’t lend to at all – and charge them exorbitantly high rates.
Victims of Predatory Lending
Although predatory loans can affect anyone, some groups of people are particularly likely targets for predatory lenders. They include:
- Subprime Borrowers. Subprime borrowers are those with poor credit scores – typically less than 630 – and low incomes. As noted above, predatory lenders often deliberately go after these borrowers so they can charge them higher interest.
- Low-Income Families. Low-income families often end up paying more for loans even if their credit is good. Practices like reverse redlining can force these borrowers into predatory loans, even when they could qualify for a decent loan. Also, a 2015 report by the Center for Responsible Lending (CRL) points out that low-income borrowers are particularly likely to use specific types of loans that are inherently abusive, such as payday loans, car title loans, and bank overdraft fees. Low-income families are also more likely to send their kids to for-profit colleges, resulting in above-average student loan debt with a below-average payoff in terms of job opportunities.
- People of Color. African-American and Latino borrowers tend to pay more for loans than white borrowers with comparable credit scores. According to the CRL report, people of color are more than three times as likely to receive high-cost mortgage loans, and they pay an extra 0.2% to 0.3% in interest for car loans. African-Americans are more than twice as likely as whites to use payday loans, and they’re nearly three times as likely to enroll at for-profit colleges.
- Elderly People. Elderly homeowners are popular targets for predatory mortgage lenders. These homeowners often have fixed incomes that aren’t enough to cover the cost of home repairs, medical care, and other expenses. A fact sheet from the National Consumer Law Center explains how lenders encourage the elderly to meet their financial needs by tapping into their home equity, then offer them loans with high interest and unfavorable terms.
- Military Service Members. Many predatory lenders target members of the armed forces. Service members are often young, with limited credit ratings, reducing the options available to them for borrowing. Older service members who have families often struggle to make ends meet as they deal with repeated deployments and relocations. A 2006 report by the Department of Defense found that predatory lenders tend to locate their offices near military bases and market their services – particularly products like payday loans, car title loans, and unsecured installment loans – heavily to service members.
- People Facing a Financial Crisis. Finally, predatory lenders often seek out people who need cash in a hurry because of some financial emergency. It could be a job loss, major home repair, or health problem resulting in high medical bills.
Lenders use a variety of strategies to find new victims. They tend to focus on specific neighborhoods with plenty of low-income, minority, or elderly residents. They blitz these areas with all forms of ads – TV, direct mail, phone calls, even door-to-door sales – that stress their loans’ low payments while ignoring their high interest rates. Often, they appeal to minority borrowers by running ads in Spanish or another foreign language common in the neighborhood.
How Predatory Lending Is Harmful
Predatory lending practices can cause major harm to both individual borrowers and society as a whole. The CRL report outlines some of the biggest problems with these loans:
- High Default Rates. Abusive loans are more likely to end in default, repossession, or foreclosure. For example, people who get car loans from auto dealerships, which often use predatory lending practices, are twice as likely have their cars repossessed as those who financed the loan through a bank or credit union.
- Damaged Credit Scores. People who default on predatory loans cause serious, long-term damage to their credit. Not only are they likely to pay more for any loan in the future, but they can also hurt their chances of getting a job, an apartment, or insurance. Roughly one in seven job-seekers with damaged credit has been turned down for a job after a credit check.
- Debt Traps. Once borrowers have taken out one abusive loan, they’re likely to end up taking out another to make ends meet, trapping them in an ongoing cycle of debt. Their debts can also limit their ability to use other financial products. For instance, borrowers struggling with payday loans often end up overdrawing their bank accounts repeatedly. If it happens too often, they can lose their bank account, forcing them to rely on costly “fringe financial products” such as check-cashing services.
- Lost Homes. Losing your home to foreclosure is a serious blow, financially and emotionally. Not only does it force you to move in a hurry, but it also stops you from building wealth through home equity. The CRL report estimates that families that lost their homes during the subprime mortgage crisis ended up $18,000 poorer, on average, than those who kept their homes. In the most extreme cases, foreclosure can even lead to homelessness.
- Falling Property Values. Foreclosures don’t just hurt individual homeowners; they hurt whole communities. Each time a home goes into foreclosure, it drives down property values for the rest of the neighborhood. In areas with high rates of foreclosure – which are usually low-income and minority neighborhoods – the value of an average home falls by around $23,150.
- Weaker Communities. Multiply that $23,150 in lost wealth by all the homes in a neighborhood, and that’s a lot of wealth flowing out of the area. That leaves less money behind to spend on all the things that make a community work, such as good schools, local businesses, and community resources. Thus, predatory lending can speed up the decay of struggling neighborhoods.
- Damage to the Economy. During the Great Recession, which was triggered by subprime mortgage lending, the U.S. economy lost 8.4 million jobs and roughly $10 trillion in economic output. Today, there is evidence that student loan debt is similarly holding back economic growth, particularly for young families.
- Increased Inequality. Predatory lending works like Robin Hood in reverse: It steals from the poor, who are the main targets of abusive loans, and gives to the rich who hold stock in large banks. Thus, these loans increase the problem of wealth and income inequality across society. The growing gaps between rich and poor, and between whites and minorities, don’t just hurt the poor; they hurt the entire nation. A 2015 report from the International Monetary Fund (IMF) found that higher income inequality in a country can limit economic growth, and studies in happiness economics have generally found that people in countries with higher inequality are unhappier overall.
- Damage to Financial Institutions. Banks that make predatory loans don’t just hurt their customers; they can also hurt their own bottom line. CRL found that during the last recession, banks with abusive credit card practices consistently suffered bigger losses than other banks. However, the damage isn’t always confined to the predatory lenders. Borrowers dealing with predatory loans often can’t afford to meet all their debt payments, so they fall behind or default on loans from other banks. Moreover, the more people see of predatory loans and their effects, the less trust they have in the financial system as a whole. This makes them more likely to avoid banking products and rely on cash, which costs banks business.
Protections for Consumers
Over the years, the U.S. government has enacted several protections to make it harder for lenders to take unfair advantage of borrowers. These include:
- The Truth in Lending Act (TILA). This 1968 law forces lenders to disclose the terms of a loan to borrowers, in writing, before they sign a contract. Lenders must clearly state the amount of the loan, the annual percentage rate (APR), any fees involved, the payment schedule, and the total of all payments. The law also gives customers who are refinancing a mortgage the right of rescission, or the ability to cancel the loan within three days after signing it.
- The Credit CARD Act. The Credit Card Accountability Responsibility and Disclosure Act of 2009, or Credit CARD Act, puts limits on a range of credit card practices that hurt consumers. For instance, it requires credit card issuers to tell users about interest rate increases, bars them from applying new rates to old balances, and requires fees and penalties to be “reasonable.” According to the CRL, this act has eliminated over $4 billion in abusive fees and saved consumers $12.6 billion per year.
- The Equal Credit Opportunity Act (ECOA). Passed in 1989, the ECOA requires banks and other lenders to make credit available equally to everyone with the same credit rating. Under this law, lenders cannot charge borrowers higher interest rates or fees based on race, color, religion, national origin, age, sex, marital status, or whether they receive any form of public assistance.
- The Home Ownership and Equity Protection Act (HOEPA). This law was passed in 1994 as an amendment to the TILA. It bans abusive practices in high-interest home loans, such as equity stripping. Under the HOEPA, any loans considered high-cost are subject to stricter disclosure rules than ordinary loans.
- The Military Lending Act (MLA). Passed in 2006 and strengthened in 2012, this law forbids lenders to charge service members more than 36% APR on any loan, including payday loans. It also prohibits loan flipping on loans to military personnel.
- Dodd-Frank. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 established the Consumer Finance Protection Bureau (CFPB) to police the finance industry. It provides information for consumers and a complaint form they can use to report predatory lenders.
- State Laws. In addition to these federal laws, many state laws limit predatory practices. According to Debt.org, 25 states have laws against predatory lending, and 35 states limit the maximum prepayment penalty on home loans.
How to Avoid Predatory Loans
While the laws listed above make predatory lending harder to get away with, they haven’t stopped the practice. Many lenders either find ways around the laws or break them outright. For instance, reverse redlining is illegal under the ECOA, but it still goes on today.
Moreover, Trump-era appointees at the CFPB are gradually weakening many of the laws designed to protect consumers. For instance, until recently, the CFPB routinely checked up on military lenders to make sure they were complying with the MLA. However, in August 2018, the CFPB announced that it would halt these routine examinations and only look at lenders that received actual complaints.
A month later, the CFPB announced that it would no longer enforce the ECOA, leading to protests from attorneys general in 14 states. And in February 2019, The Hill reported that the new CFPB head, Kathy Kraninger, was taking steps to roll back Obama-era limits on payday loans.
The bottom line is: To protect yourself against predatory loans, you need to take matters into your own hands. That means knowing how to spot an abusive loan, proceeding with caution whenever you borrow money, and knowing about alternatives to predatory loans.
Warning Signs of Predatory Loans
The key to avoiding predatory loans is being able to recognize one when you see it. Financial experts say these are the most important warning signs to watch out for:
- It’s Too Good to Be True. Predatory lenders often lure you in with promises of fast cash, easy approval, or ultra-low interest rates, regardless of your credit score. However, deals like this almost always come with a hidden cost: high fees, interest rates that jump after a few months, or being forced to risk your home or car as security. Treat any amazing-sounding offer as a red flag and read the fine print extra-carefully.
- You Can’t Tell What It Costs. Regular lenders always provide a disclosure that tells you all the costs associated with a loan, including APR, term length, fees, and prepayment penalties. Predatory lenders, on the other hand, go out of their way to conceal these costs. If a lender isn’t giving you all the info you need to evaluate a loan up front, look for another lender.
- The Rates and Fees Seem Too High. The MLA and many state laws cap the interest rates on loans at 36% APR. If the rate on your loan is higher than that – or if it starts low but could rise dramatically in the future – it’s almost sure to be unaffordable. Other features to watch out for are fees that add up to more than the actual amount you’re borrowing, steep prepayment penalties, and other services “packed” with the loan, such as credit insurance.
- The Lender Isn’t Licensed. Be suspicious of any loan offer that comes to you through the mail, over the phone, or from someone who shows up at your door. Reputable lenders generally don’t sell their services this way. If you’re interested in checking out the offer anyway, do a quick search on the lender to make sure it’s licensed to operate in your state. If it’s not, you’re dealing with a private money lender who isn’t subject to any banking laws – in other words, a likely loan shark.
- The Lender Doesn’t Check Your Credit. Before approving you for a loan, most lenders check your credit to see what you can afford and how good you are at handling debt. If lenders skip this step, it means they’re not worried about whether you can pay back the loan. They’re planning to get money out of you some other way – through exorbitant interest, high fees, using your car as collateral, or gaining direct access to your checking account. That means the lender will be fine whether you can pay the loan or not, but you won’t.
- The Loan Doesn’t Help You Build Credit. A good lender will report your loan payments to credit bureaus, helping you build up a good credit rating. However, many predatory lenders, such as payday lenders, don’t generally bother to do this. You can’t improve your credit score by borrowing from them, but you can still damage it if you fail to pay back the loan and it goes to collections. It’s a no-win situation.
- The Lender Requires Electronic Payments. The key word here is “requires.” Many lenders offer automatic payments, which require them to have access to your bank account. However, if the lender won’t let allow you to pay any other way, watch out. If you don’t have enough money in your account to meet a payment, these lenders are likely to keep requesting the same payment over and over until they get it, hitting you with a hefty overdraft fee each time.
- There Are Blank Spaces in the Paperwork. This is a huge red flag. The only reason for a lender to leave big blank spaces in a contract is so they can fill them in after you’ve signed it, making it look like you agreed to terms you never knew about. Check all contracts carefully, and never, ever sign one that contains blank spaces.
- You Can’t Get a Straight Answer. Predatory lenders often try to rush you through the process, not giving you time to read the documents carefully and ask questions. If there’s anything in the contract you can’t understand, and the lender won’t explain it to you clearly, that’s a sure sign they’re trying to hide something.
- Others Have Complained About the Lender. Before taking out a loan, do a little work to make sure the lender is trustworthy, the same way you’d check out online reviews before buying a new computer. First, search for the lender’s name on the Federal Trade Commission’s Scam Alerts page and the CFPB’s Consumer Complaint Database. Then check out its rating and customer reviews at the Better Business Bureau. Even a reliable lender is likely to have a few complaints, but if the bad reviews outnumber the good ones, you can do better.
How to Protect Yourself
To find an honest, reputable lender, simply take all the warning signs listed above and reverse them. A good lender will check your credit and won’t lend you more than you can reasonably afford to pay. It will clearly disclose all costs, help you understand all the details of your loan, and it won’t try to pressure you into anything. It also won’t have a lot of complaints from users.
However, even when working with a decent lender, it makes sense to be cautious and check the fine print. Here are some tips to keep in mind:
- Know What You Can Afford. Before you start shopping for a loan, figure out how much debt you can reasonably manage to carry. To do this, find your debt-to-income ratio (DTI), which is your monthly debt payments divided by income. Ideally, your new loan should not push your DTI above 36%.
- Shop Around. Treat shopping for a loan like looking for a home contractor and get quotes from at least three lenders. Check on all the lenders to make sure they’re licensed.
- Ask Lots of Questions. After you’ve settled on a lender to work with, make sure you understand all the details of your loan deal. Ask whether your monthly payments will change at any point during the loan term, whether there’s a prepayment penalty, and what’s included in each payment, such as taxes or insurance. Also, find out whether the type of loan you’re getting has a three-day right of rescission. Question any add-ons or fees that don’t seem reasonable to you.
- Take Your Time. Don’t let the lender rush you at any point in the loan process, and don’t sign any waiver of rights. For mortgage loans, make sure you get your settlement statement at least three days before closing and take the time to read it in full.
- Stop for Red Flags. If your lender asks you to sign a waiver of rights, or hands you a contract that contains blank spaces, stop right there and back out of the deal, even if you’re right on the verge of closing. It’s better to start all over than get trapped in a predatory loan for years to come.
Alternatives to Predatory Loans
If you have poor credit, finding an affordable loan from an honest lender can be difficult. However, even in this situation, you have options, including some that don’t involve borrowing at all. Before giving in and accepting an abusive loan, look into these alternatives:
- Payday Alternative Loans. Most federal credit unions offer small, short-term loans called payday alternative loans, or PALs. If you’ve been a member of the credit union for at least one month, you can borrow between $200 and $1,000 for a term of one to six months. The maximum APR on these loans is 28%, and application fees are capped at $20. Rollovers on these loans are not permitted, so you can’t get trapped in a cycle of debt. Also, most credit unions report PAL payments to the credit bureaus, so this type of loan can help you build credit.
- Paycheck Advances. If you need a little extra money to tide you over until your next payday, try asking your employer if you can get an advance on your paycheck. This isn’t the same as a loan; it’s just getting paid early for work you’ve already done. If your employer can’t help you, look into using a bank account from Chime to get an advance on your own. You’ll have the chance to get paid two days early when you use direct deposit.
- Loans From Family or Friends. The “bank of Mom and Dad” can probably offer you better rates and terms than any real bank. However, loans from friends and family can put a strain on your relationships, especially if you have trouble paying them back. To make the process smoother, explain exactly why you need the money and write up a loan agreement, just as you would with a bank. Arrange to pay back all the money, with interest, on a strict schedule, and then stick to it.
- Government or Charitable Aid. If you’re looking for a loan to make ends meet, consider seeking emergency assistance instead. There are many government programs and charitable agencies that can help you supplement lost income and pay for housing, food, utilities, health care, and education. There are also organizations like the National Foundation for Credit Counseling to help you manage your finances better and get debt under control.
- Negotiating With Lenders. If you need a loan to meet your payments on other debts, it could make more sense to negotiate with your creditors instead. Often, lenders are willing to work out a payment plan with you or even accept a lump-sum payment that’s less than your total debt. That way, they don’t run the risk that you’ll file for bankruptcy and they’ll get nothing.
Fighting Back Against Predatory Loans
Unfortunately, for some people, it’s too late to avoid a predatory loan. If you’re already caught in one, what you need to know is how to get out. Escaping from a predatory loan is trickier than avoiding it in the first place, but there are a few things you can try.
1. Report the Lender
First of all, report the lender who sold you the predatory loan. File a complaint with the CFPB and with your state’s banking office, which you can find through the CFPB site. If the lender deliberately lied to or misled you about a loan, you can report it to the Federal Trade Commission for fraud as well.
You can report predatory lenders even if you didn’t decide to take out a loan with them. By doing this, you’ll help stop their abusive practices from hurting other consumers.
2. Use Your Right of Rescission
Under the TILA, all home equity loans and lines of credit, and many refinance loans, come with the right of rescission. That means you can cancel the loan, no questions asked, within three days after signing it. The TILA requires lenders to provide borrowers with a Notice of Rescission that notifies them of this right and explains how to exercise it. If your Notice of Rescission does not clearly explain what to do, then send a written statement to the bank within the three-day period that clearly states you want to cancel the loan.
However, some predatory lenders deliberately fail to provide this disclosure. If your lender didn’t give you a Notice of Rescission, or the notice wasn’t accurate, this could make the entire loan agreement invalid. According to the CFPB, this would allow you to rescind the agreement at any time within three years after signing it, rather than three days. If you think this situation applies to you, consult a lawyer.
3. Sue the Lender
If your loan agreement contains terms that clearly violate the TILA or some other federal or state lending law, you could have grounds for a civil lawsuit. According to Mortgage 101, if you file a lawsuit over a predatory mortgage loan, you can collect up to twice the amount of the finance charges the company levied against you. Talk to a lawyer to find out whether a lawsuit is an option for you and how much it will cost.
However, be aware that predatory lenders often protect themselves from lawsuits by including a mandatory arbitration clause in the loan agreement. This clause legally bars you from suing the lender for fraud or misrepresentation. Instead, you have to take the case to an arbitrator hired by the company, a situation that’s designed to put you at a disadvantage.
4. Refinance the Loan
In many cases, you can escape from a predatory secured loan, such as a mortgage or car loan, by refinancing it with a different lender. When you refinance, you’re effectively taking out a new loan to pay off your current, abusive one. This lets you trade in the old loan for a new loan with more favorable terms, such as lower interest and fees.
Of course, predatory lenders often try to discourage you from doing this with steep prepayment penalties. However, paying the penalty could still end up being cheaper than sticking with your existing high-cost loan. Shop around for new lenders and have them crunch the numbers to see how much a new loan would cost you in total.
One option you might want to consider is SoFi. They have options for refinancing home loans and student loans, plus they also offer personal loans. These can be perfect for consolidating high interest debt.
There’s a lot you can do as an individual to protect yourself from predatory loans. You can learn to recognize and avoid them ahead of time, and you can use various strategies to get out of a predatory loan if you’re stuck in one.
However, it’s much harder to stop the damage predatory lenders do to our economy and society as a whole. The best way to do that is to pass stronger legal protections for borrowers and do more to enforce the laws we already have. Unfortunately, right now, the government seems to be doing precisely the opposite: rolling back existing protections and making less effort to enforce them.
The only way to fight this trend is to act as a citizen, rather than as a consumer. Read the news, and when you hear about a new proposed law that you think is good or bad for consumers, call or write to your representatives in Congress to let them know how you feel. And when the next election rolls around, pay attention to what the candidates have to say about consumer issues and vote accordingly.
Have you ever been the victim of a predatory loan? What happened?