Predatory lending refers to practices where lenders coerce a borrower to agree to a loan that is unfair, abusive, or dishonest. Many Individual Development Account (IDA) programs find that their participants either use or have used businesses that engage in predatory lending. In any situation where a person is willing to borrow money, there is a potential for predatory lending practices. Understanding how some of these businesses operate, and alternatives participants have for the services they provide, can help staff help their clients preserve income, reduce expenses, and have more money to save.
This article explores four common predatory practices, discusses ways to avoid these practices and offers practical tips for discussing predatory lending with IDA project participants.
Types of Predatory Lending
1. Subprime Mortgages
Subprime mortgages are loans for homes made to people who generally cannot qualify for conventional mortgages due to a poor credit history, a low credit score, or lack of income. Subprime mortgages are also targeted at first time home buyers and seniors.1
In May 2009, 43 percent of all foreclosures in the U.S. involved borrowers who had purchased subprime mortgages.2 This was down from 54 percent in 2008. Defaults on subprime mortgages contributed to the economic recession during this time period.
A subprime mortgage is deemed predatory when it involves one or more of the following characteristics and lending practices which results in a borrower paying more for the load than he or she should3:
2. Pay Day Loans
Pay day lenders provide small, short-term loans to individuals and families strapped for cash. Someone in need of cash presents a pay day lender with a post dated check4 or an authorization from the borrower’s bank account for some time in the future (usually within two weeks) as security for the loan. The borrower gets cash from the lender minus a fee for the loan. If the borrower does not have the funds at the designated time in the future they pay an additional fee to extend the loan.
Pay day lending is a $59 billion dollar industry with an estimated 23,000 pay day lending operations in the U.S. today.5 The average customer takes out eight to ten loans a year, averaging about $3006 each, and can pay up to 400 percent annual percentage rate7 (the bi-weekly fee annualized).
Pay day lenders do fill a large gap in the financial services industry by providing cash for people living paycheck to paycheck. Pay day lenders do not require credit checks or long forms for borrowers to sign to get the cash they need to tie them over until they are paid again. The tragedy of pay day lending for many of the borrowers is that people often get trapped in these loans. They never have enough to pay back the loan and pay for their expenses, so they keep renewing the loan.
3. Car Title Loans
Car title loans are another means by which borrowers can access cash by using their car title to secure loans. Similar to the fees pay day lenders charge, car title loan providers charge fees that can approach annual percentage rates of 250 percent or higher.8 Car title loans are generally given for only a percentage of the value of the car (25 or 50 percent), but collateralized by the full value of the car. This means when a person defaults on the loan – cannot make the payment – the lenders gain ownership of the car. The borrower loses the car, which is worth more than the value of the loan.
As with pay day loans, extending the loan for a longer period is common practice among these lenders and borrowers. This practice causes fees to accumulate on top of the principal owed, and borrowers are forced to continue rolling over the loan or coming up with the cash to cover the principal and fees. Non-payment of the loan can result in repossession of the car, interrupting a person’s ability to take care of essentials like travel to work or driving children to school.
4. Overdraft Protection
Overdraft protection often occurs automatically if people overdraw on their accounts by making a debit card transaction. In theory, overdraft protection is beneficial because it prevents account holders from being charged non-sufficient fund (NSF) fees by the merchant and the financial institution.
As of July 1, 2010, financial institutions that offer overdraft protection for ATM withdrawals and debit card transactions must notify consumers of their right to choose, or “opt in” to, this service. This notice must also provide a clear explanation of the fees associated with the service. If the consumer declines overdraft protection, the financial institution is prohibited from charging the fee for the overdraft protection.9
If a person chooses overdraft protection, any transactions that generate an overdraft will incur a fee. Since no alert to the overdraft is given at the time of the purchase, the person is not given the option to void the transaction and avoid the overdraft. A person could end up making multiple transactions on his or her card even though it is overdrawn, with each transaction generating an additional overdraft fee.
Ways to Avoid Predatory Practices
A first step in helping IDA project participants steer clear of predatory financial products is to explain why people use these services.
While predatory lending practices can have a devastating financial impact, borrowers can take the following steps to protect themselves.10
How to Avoid Pay Day and Car Title Loans
Establishing emergency savings is the best way to avoid having to utilize pay day or car title loans when short on cash. Building a sufficient emergency fund, however, can take time. In cases a person does not have emergency savings, they can try to find public resources to cover the gap, such as programs that assist households with paying their heating bills in the winter. Finally, credit cards, while expensive, are generally going to be less expensive than most pay day or car title loans and do not put the person’s car on the line in case of late or non-payment.
How to Avoid Overdraft Protection Charges
As of July 2010, consumers can decide whether they want to “opt in” for overdraft protection. Some may choose overdraft protection because it creates a sense of security, even if it ends up being quite costly when overdraft fees are incurred.
The most obvious answer is often the hardest for people to implement—keeping a check register and tracking all checks and debit card transactions. People can also be counseled to use cash – not checks or debit cards – for small purchases to avoid the possibility of being charged a large overdraft fee on a small purchase. Compare checking accounts at different financial institutions and ask specific questions about their overdraft protection. Choose the account with the most favorable rates.
Practical Tips for Discussing Predatory Lending with AFI Participants
In helping IDA project participants avoid predatory financial services, proceed in a sensitive way. Calling these practices “predatory,” at least initially, can be off-putting because it may create a sense of shame for having fallen for these tactics, making participants feel ignorant.
Using the term alternative or higher cost financial services can be a way of differentiating these services from their prime counterparts.
Here are some other tips for covering this topic with AFI participants:
There are resources available to help borrowers avoid becoming a victim of predatory lending and to assist borrowers who have already become victimized.11
Avoiding Predatory Lending
For information about loan fraud and advice about preventing it, see Don't Be A Victim of Loan Fraud (http://www.hud.gov/offices/hsg/sfh/buying/loanfraud.cfm )and a list of Local Resources (http://www.hud.gov/buying/localpredlend.cfm).
Assistance with FHA loans
The FHA Resource Center (http://www.hud.gov/offices/hsg/sfh/fharesourcectr.cfm) can assist with problems relating to origination, underwriting, or appraisals of FHA loans. Contact the HUD National Servicing Center (http://www.hud.gov/offices/hsg/sfh/nsc/nschome.cfm) for information on avoiding foreclosure on an FHA loan
Assistance with Non-FHA mortgage loans
To file a complaint regarding predatory practices on a non-FHA loan, refer to this list (http://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/ramh/res/resrefer) of contacts.
Borrowers facing foreclosure can locate a housing counseling agency (http://portal.hud.gov/portal/page/portal/HUD/i_want_to/talk_to_a_housing_counselor) near them.
The RESPA web page (http://www.hud.gov/offices/hsg/ramh/res/respa_hm.cfm) provides information on RESPA disclosure requirements such as the Good Faith Estimate, HUD-1 and escrow account statements, and how to file a complaint with your lender concerning the servicing of your loan.
Housing Discrimination Complaints
Learn how the Fair Housing Act (http://portal.hud.gov/portal/page/portal/HUD/topics/fair_lending) can help fight predatory lending.
1 U.S. Department of Housing and Urban Development. www.hud.gov.
2 Howley, Kathleen M. (May 2009) Mortgage Delinquencies, Foreclosures Rate Increase. Bloomberg News
3 Frame, S., Lehnert, A., and Prescott, N. (2008). A Snapshot of Mortgage Conditions with an Emphasis on Subprime Mortgage Performance. Federal Reserve Bank.
4 “Post dated” means a check that is written today, but dated a date in the future. If presented for payment today, it would not be valid.
5 CBS Evening News, July 29, 2008.
6 Credit Infocenter. www.creditinfocenter.com
7 Center for Responsible Lending. www.responsiblelending.org
8 Why car title loans are a bad idea by Christopher Neiger. Article.
9 Federal Reserve Board of Governors. Press release dated November 12, 2009.
10 “How to Avoid Predatory Lending.” November 20, 2008. http://www.freddiemac.com/corporate/buyown/english/mortgages/lenders/avoiding_predlend.html
11 List of resources compiled by the U.S. Department of Housing and Urban Development. http://www.hud.gov/offices/hsg/sfh/pred/predlend.cfm