Predatory Lending

Introduction

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:

• Steering and Coercing.  Aggressive sales tactics are used to steer and coerce borrowers toward loans that they could not afford, even though they could have qualified for regular prime loans.
• Excessive Fees. These fees are incorporated into the load amount to disguise them or hide them from the borrower. The borrower not only pays these unnecessary fees but also ends up paying interest on the fee amount since the fees are built in the loan.
• Excessive Insurance and Other Unnecessary Products.  Some lenders either insist on or intimidate borrowers into buying these unnecessary items. Just like with excessive fees, they get incorporated into the loan amount and the borrower pays interest on them over the life of the loan. (Note: While mortgage loans typically require some types of insurance, a borrower may decide to pay for this insurance separately and not roll the cost into the mortgage loan amount.)
• Abusive and Abnormal Prepayment Penalties.  Prepayment penalties are fees lenders require borrowers to pay if the borrower pays off the mortgage loan early.  Prepayment penalties on subprime mortgages can be so high that homeowners who want to refinance can be trapped into keeping the original, high-interest mortgage.  (Most loans that are not subprime loans do not include prepayment penalties.)
• Loan Flipping. Homeowners are talked or coerced into refinancing their mortgage even when they gain nothing from the transaction, since the money realized from the transaction is offset by the excessive fees, higher interest rate, and prepayment penalties of the new mortgage.  In addition, the borrower risks losing their home when a balloon payment is inserted into the fine print of the loan agreement. A balloon payment is when the outstanding balance of a loan is due at one time at some date in the future. This is written into the terms of a loan.
• Mandatory Arbitration.  Language is included in the fine print of the loan terms and conditions making it illegal for the homeowner to take legal action against the lender.  The loan documents require the borrower to submit to arbitration, that is to be controlled by the lenders. Borrowers can find it difficult to find legal representation for mandatory arbitration proceedings.

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

• Be informed.  Contact a housing counseling agency or attend a homeownership education course if the borrower has any questions with the home buying process.
• Know who you are working with. Check references.  Request a list of references for real estate professionals and lenders and contact the references before selecting whom to work with. 
• Research market.  Before making an offer on a house, research the sale prices of comparable houses in the neighborhood by asking a realtor to run a “comp” (comparison) list of recent sales. This can help ensure that the buyer does not make an offer that is too high for the house or neighborhood.
• Get a home inspection.  Insist on a home inspection and do not necessarily use the home inspector the real estate agent or lender recommends. Ask friends or neighbors who have recently purchased a home for the name of a home inspector that they used and liked. 
• Be truthful.  Never make false statements on loan application paperwork.  Not only is this fraud, but it could result in the borrower assuming a mortgage that is not affordable.
• Understand what you sign. Ask questions if language in a loan document is not clear and never sign a blank document.  Be sure to know what the loan amount includes. While it is common for the loan amount to include the actual amount borrowed plus Private Mortgage Insurance and closing costs, the borrower should ensure that additional costs that he or she does not need or want, such as premium credit insurance, are not included.

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:

• Explain in clear terms how each type of alternative or higher cost (predatory) lending works.
• Identify reasons people use these products.
• Conduct exercises that calculate the cost of using these services; compare these with costs of preferable alternatives.
• Identify alternatives for using these services during emergencies (especially pay day loans and car title loans); develop a list of appropriate local resources that might help out.
• Explain some of the approaches (tactics) used, especially with predatory subprime loans, so they can identify them in the future.
• Provide opportunities to practice tracking transactions in check registers.

Resources

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.

Foreclosure

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.

Settlement Procedures

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