What Is Predatory Lending?
Predatory lending typically refers to lending practices that impose unfair and abusive loan terms on borrowers. In many cases, these loans carry high fees and interest rates, strip the borrower of equity, or place a creditworthy borrower in a lower credit-rated (and more expensive) loan, all to the benefit of the lender. Predatory lenders often use aggressive sales tactics and take advantage of borrowers’ lack of understanding of financial transactions. Through deceptive or fraudulent actions and lack of transparency, they entice, induce, and assist a borrower to take a loan that they will not reasonably be able to pay back.
- Predatory lending is any practice of a lender that imposes unfair and abusive loan terms on borrowers, including high interest rates, high fees, and terms that strip the borrower of equity.
- Predatory lenders often use aggressive sales tactics and deception to get borrowers to take on loans they can't afford.
- They typically target vulnerable populations, such as those struggling to meet monthly expenses; people who have recently lost their jobs; and those who are denied access to a wider range of credit options for illegal reasons, such as discrimination; consumers who do not have a high school education or the equivalent; and older adults.
- Predatory lending disproportionately affects women, and African-American and Latinx communities.
How Predatory Lending Works
Predatory lending includes any unscrupulous practices carried out by lenders to entice, induce, mislead and assist borrowers in taking loans that they otherwise are unable to pay back reasonably or pay back with extremely high cost not in line with the market. Predatory lenders take advantage of borrower's circumstances or ignorance.
A loan shark, for instance, is the archetypal example of a predatory lender—someone who loans money at an extremely high interest rate and may even threaten violence to collect on their debts. But much predatory lending is done by more established institutions including banks, finance companies, mortgage brokers, attorneys, or real estate contractors.
Predatory lending puts many borrowers at risk, but it especially targets those with few credit options or who are vulnerable in other ways—people whose inadequate income leads to regular and urgent needs for cash to make ends meet, those with low credit scores, the less educated, or those subject to discriminatory lending practices because of their race or ethnicity. Predatory lenders often target communities where few other credit options exist, which makes it more difficult for borrowers to shop around. They lure customers with aggressive sales tactics by mail, phone, TV, radio and even door-to-door. They use a variety of unfair and deceptive tactics to profit.
Above all, predatory lending benefits the lender and ignores or hinders the borrower’s ability to repay a debt.
Predatory Lending Tactics to Watch Out For
Predatory lending is designed, above all, to benefit the lender; it ignores or hinders the borrower’s ability to repay a debt. Lending tactics are often deceptive and attempt to take advantage of a borrower’s lack of understanding of financial terms and the rules surrounding loans. The Federal Deposit Insurance Corporation (FDIC) gives some common examples:
- Excessive and abusive fees. These are often disguised or downplayed, as they are not included in the interest rate of a loan. According to the FDIC, fees totaling more than 5% of the loan amount are not uncommon. Excessive prepayment penalties are one example.
- Balloon payment. This is one very large payment at the end of a loan's term, often used by predatory lenders to make your monthly payment look low. The problem is you may not be able to afford the balloon payment and will have to refinance, incurring new costs, or default.
- Loan flipping. The lender pressures a borrower to refinance again and again, generating fees and points for the lender each time. As a result, a borrower can end up trapped by an escalating debt burden.
- Asset-based lending and equity stripping. The lender grants a loan based on your asset (a home or a car, say) rather than on your ability to repay the loan. When you fall behind on payments, you risk losing your home or car. Equity-rich, cash-poor older adults on fixed incomes may be targeted with loans (say, for a house repair) that will have difficulty repaying and will jeopardize their equity in their home.
- Unnecessary add-on products or services, such as single-premium credit life insurance for a mortgage.
- Steering. Lenders steer borrowers into expensive subprime loans, even when their credit history and other factors qualify them for prime loans.
- Reverse redlining. Redlining, the racist housing policy that effectively blocked Black families from getting mortgages, was outlawed by the Fair Housing Act of 1968. But redlined neighborhoods, which are still largely inhabited by African American and Latinx residents, are targeted by predatory and subprime lenders.
Common Types of Predatory Loans
Classic predatory lending centers around home mortgages. Since home loans are backed by a borrower’s real property, a predatory lender can profit not only from loan terms stacked in their favor but also from the sale of a foreclosed home, if a borrower defaults. Subprime loans aren’t automatically predatory. Their higher interest rates, banks would argue, reflect the greater cost of riskier lending to consumers with flawed credit. But even without deceptive practices, a subprime loan is riskier for borrowers because of the great financial burden it represents. And with the explosive growth of subprime loans came the potential for predatory lending. When the housing market crashed and a foreclosure crisis precipitated the Great Recession, homeowners with subprime mortgages were vulnerable. Subprime loans came to represent a disproportionate percentage of residential foreclosures.
African American and Latinx homeowners were particularly affected. Predatory mortgage lenders had targeted them aggressively in predominantly minority neighborhoods, regardless of their income or creditworthiness. Even after controlling for credit score and other risk factors, such as loan-to-value ratio, subordinate liens, and debt-to-income ratios, data shows that African Americans and Latinos were more likely to receive subprime loans at higher costs. Women, too, were targeted during the housing boom, regardless of their income or credit rating. African American and Latina women with the highest incomes were five times more likely than white men of similar incomes, to receive subprime loans.
In 2012, Wells Fargo reached a $175 billion settlement with the Justice Department to compensate African American and Latinx borrowers who qualified for loans and were charged higher fees or rates or were improperly steered into subprime loans. Other banks also paid settlements. But the damage to families of color is lasting. Homeowners not only lost their homes, but the chance to recover their investment when housing prices climbed back up, contributing yet again to the racial wealth gap. (In 2019, the typical white family had eight times the wealth of the typical Black family and five times the wealth of the typical Latinx family.)
The payday loan industry lends $90 billion annually in small-dollar, high-cost loans (annualized interest rates can be 400% ) as a bridge to the next payday. Payday lenders operate online and through storefronts largely in financially under-served—and disproportionately African American and Latinx—neighborhoods. Some 12 million Americans make use of payday loans, the majority of whom are women and people of color, according to Pew Charitable Trusts studies. Stagnant wages and a growing wealth gap have been cited as contributing factors, along with aggressive lobbying by payday lenders.
Borrowers use payday loans not for one-time emergencies for a couple of weeks, but to cover ordinary living expenses like rent and groceries—\over the course of months. According to Pew 80% of payday loans are taken out within two weeks of a previous payday loan, and the average payday loan customer pays $520 a year in fees to repeatedly borrow $325 in credit.
With new fees added each time a payday loan is refinanced, the debt can easily spiral out of control. A 2019 study found that using payday loans doubles the rate of personal bankruptcy by worsening the cash flow position of the household, the researchers concluded. The economic impact of COVID-19, with no new stimulus payments on the horizon, means that more cash-strapped consumers could become vulnerable to these predatory loans.
These are single-payment loans based on a percentage of your car's value, for quick cash. They carry high interest rates, but in addition, you have to hand over the vehicle's title and a spare set of keys as collateral. For the one in five borrowers who have their vehicle seized because they're unable to repay the loan, it's not just a financial loss, but can also threaten access to jobs and child care for a family.
New forms of predatory lending
New schemes are popping up in the so-called gig economy. For instance, Uber, the ride-sharing service, agreed to a $20 million settlement with the Federal Trade Commission (FTC) in 2017, in part for auto loans with questionable credit terms extended to the platform's drivers. Elsewhere, many fintech firms are launching products called " buy now, pay later." These products are not always clear about fees and interest rates and may entice consumers to fall into a debt spiral they will not be able to overcome.
Is Anything Being Done About Predatory Lending?
To protect consumers, many states have anti-predatory lending laws. For instance, payday lending is prohibited in 14 states and Washington, D.C. The U.S. Department of Housing and Urban Development (HUD) has also taken measures to combat predatory lending, as has the Consumer Financial Protection Bureau (CFPB). In June 2016, for instance, CFPB issued a final rule establishing stricter regulations for underwriting of payday and auto-title loans. But in July 2020, under new leadership, CFPB revoked that rule and delayed other actions, considerably weakening federal consumer protections against these predatory lenders.
How to Avoid Predatory Lending
- Educate yourself. Becoming more financially literate helps borrowers spot red flags and avoid questionable lenders. The FDIC has tips on protecting yourself when you take on a mortgage, including instructions for cancelling private mortgage insurance (paid for by you, it's to protect the lender). HUD gives advice on mortgages. CFPB has guidance on payday loans.
- Shop around for your loan before you sign on the dotted line (although it's understandable that if you've experienced lending discrimination in the past, you just want to get the process over as soon as possible). Comparing offers will give you the advantage.
- Consider alternatives. Before taking on a costly payday loan, consider turning to family and friends, your local religious congregation, or public assistance programs, which are unlikely to cause the same financial harm.