Predatory Lending

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Predatory Lending

The practice in which a loan is made to a borrower in the hope or expectation that the borrower will default. A lender may have an incentive to commit predatory lending if he/she receives a commission for each loan made (regardless of creditworthiness), or if the lender easily can bundle and sell the mortgage to a third party, passing on the risk while still profiting. Predatory lending is illegal in many jurisdictions, though the exact definition may vary from place to place.

predatory lending

Strictly speaking,it consists of loaning money to consumers in the hope and expectation they will default and the lender will be able to take the collateral. Modern usage has expanded the term to include any lending practices that rely on a consumer's lack of sophistication,or gullibility,for the imposition of unnecessarily high interest rates,large lending fees,or both. HUD maintains a Web site for researching reports of predatory lending,and resources for persons who believe they have been victims of predatory lending: www.hud.gov/offices/hsg/sfh/pred/predlend.cfm.

Predatory Lending

A variety of unsavory lender practices designed to take advantage of unwary borrowers.

Predatory lending covers much the same ground as Mortgage Scams and Tricks/Scams by Loan Providers. The difference is that the term “predatory lending” has been associated with practices in the sub-prime market that specifically target unsophisticated and vulnerable borrowers. Scams operate across a wider spectrum and usually don't leave quite as much human wreckage in their wake.

Predatory Practices: The two most important types of predatory lending are “equity grabbing” and “price gouging.”

Equity Grabbing: This is lending that is intended by the lender to lead to default by the borrower so the lender can grab the borrower's equity.

Equity grabbing may be associated with cash-out refinancing to cash-dazzled customers. In one case, a borrower with significant
equity in his home refinanced a low interest-rate loan into one carrying a high interest rate plus heavy fees, with the fees included in the new loan. The inducement was the cash, more than the borrower had ever seen at one time. But the borrower was saddled with a larger repayment obligation that he couldn't meet, resulting in default and loss of the home.

Home improvement scams work in a similar manner. Gullible homeowners are sweet-talked into contracting for repairs for which they are overcharged, and then the cost of the repairs plus high loan fees are rolled into a mortgage that they cannot afford. Default follows and the borrower loses the home.

Equity grabs are extremely difficult to regulate away because they represent an abusive application of legitimate activities. Most borrowers who do a cash-out refinance retain their equity, and this is true as well for most of those who take out home improvement loans. There are no remedies that won't curb legitimate transactions, except perhaps for counseling directed at potential victims. But people can't be compelled to seek counsel or to listen when they receive it.

Price Gouging: This involves charging interest rates and/or fees that are excessive relative to what the same borrower would have paid had they shopped the market. It also includes packaging of related services such as credit life insurance, which are over-priced and made to appear as if they are required.

A large number of the newspaper columns I write are designed to help potential borrowers avoid price gouging. Informed borrowers who shop, even if it is only to check prices on the Internet, are very unlikely to be gouged.

Still, there are many uninformed borrowers who don't shop, and government ought to protect them if there were ways to do it that
didn't seriously harm other borrowers. Unfortunately, the regulatory reaction to price gouging is to set maximum prices, which prevents borrowers from being gouged only by depriving other borrowers of access to credit altogether. The tradeoff between protection and harm becomes increasingly unfavorable as the market widens to provide

market access to more and more consumers. As offensive as price gouging is, price controls are not a good remedy.

Targets of Predators: To educate myself on what makes a victim, I studied 51 case histories of households victimized by mortgage lenders. The histories were provided by ACORN, which has been in the forefront of the struggle against predators. While every case is different, victims share certain features that make them vulnerable to predators.

Passive: Perhaps the most pervasive characteristic of victims by far is that they are passive. They don't select a loan provider; the loan provider selects them. In more than half the cases compiled by ACORN, the victims were solicited by the lenders. In most of the remaining cases, the victims approached a lender they knew from prior experience, either their own or someone they knew.

Borrowers who passively go with a loan provider who solicits them run a high risk of getting a predator. While not all lenders who solicit are predators, all predators solicit. This means that a borrower would do better by throwing a dart at the loan providers listed in the Yellow Pages than by responding to a solicitation.

Borrowers who allow themselves to be selected by loan providers stay selected. Passive borrowers don't shop alternatives. They also don't ask as many questions as they should, which is one of the reasons they usually end up confused about the transaction.

Confused: Almost all of the case histories provided by ACORN involved confusion by the borrower about one or another feature of the transaction. In some cases, borrowers were under the impression that they were getting unsecured loans rather than mortgages. In many cases, they purchased credit life insurance under the impression that it was required. Often, they thought that they were paying a lower interest rate than was in fact the case. The total amount of fees packed into the loan balance usually surprised them. A large number did not know that their contract included a prepayment penalty until years later when they went to prepay.

Why so much confusion? Victims often don't read documents or, if they do read, they are afraid to ask questions about what they don't understand. The “Plain English” movement has not impacted

mortgage documents, although there isn't a segment of the economy that needs it more.

Predators thrive on confusion, which provides a smoke screen for their shenanigans. To a predator, a reading-challenged borrower is an invitation to take advantage in every possible way. And mortgages provide lots of ways.

Confusion and passivity go hand in hand, and must be overcome together. It is the loan provider's responsibility to eliminate confusion. If he doesn't do it, walk out the door.

Indebted: Victims are often heavily in debt, and therefore vulnerable to the siren call of debt consolidation. Debt consolidation was the primary motivation in about 2/3 of the ACORN cases.

The argument is compelling: make one lower payment and enjoy tax benefits besides. While these advantages can be real, they tend to disappear in dealing with a predator. Sometimes the payment is higher rather than lower, because of the stiff interest rate. Even if the payment is lower, the borrower's equity is depleted by the inclusion of large upfront fees in the loan. Consolidate debts with a predator and you end up worse off than you were before.

Consumers who have accumulated too much short-term debt have an option other than debt consolidation. They can instead work out a debt management plan with a credit counselor. In exchange for agreeing to take on no new debt and to pay off the old debt within a prescribed period, the counselor can get the creditors to agree to a reduction in interest rates. The consumer makes one payment to the agency, which in turn pays the creditors.

Adebt management plan is protection against falling into the hands of a predator. It also avoids one of the perils of a successful debt consolidation, which is that it paves the way for a new credit binge.

Cash-Dazzled: Many victims are cash-dazzled—the prospect of pocketing a significant sum of money causes a complete lapse of judgment. They ignore where the money is coming from and what it is costing them.

Cash-dazzled victims are prime candidates for cash-out refinancing—refinancing into loans that are larger than the outstanding balance of the old loans. Frequently, the new loan has a higher interest rate than the old one and the refinancing fees are added to the loan balance. Some borrowers will refinance again and again, a practice known as “flipping,” until they have used up all their equity.

There are many legitimate cash-out refinance transactions. They become predatory when the cash-dazzled victim agrees to terms that are far more costly than the borrower could have obtained by shopping alternative sources.

The worst rip-off is cash-out refinancing of zero-interest loans, a problem that has plagued the Habitat for Humanity program. The
Coalition for Responsible Lending estimates that 10% of all Habitat borrowers between 1987 and 1993 subsequently refinanced their zero-interest loans into loans carrying rates of 10-16%. Borrowers who did this were paying interest costs of 60% and up for the cash in their pockets. Cash-dazzled victims don't see it.

Payment-Myopic: Victims often base decisions solely on the affordability of monthly payments; they are payment-myopic. They don't consider interest costs or how the decisions will affect the equity in their homes.

Here is the kind of deal that payment-myopic/cash dazzled borrowers find irresistible. The borrower has paid down his 8% loan to
$100,000 and has only 12 years to go. He is offered a 30-year loan for $110,000 at 9%. The monthly payment would fall from $1,082 to $885, and he puts $10,000 in his pocket tax-free. What a deal!

Of course, five years down the road, he would have owed only $69,449 had he stayed with his original mortgage. With the new mortgage he will owe $105,468—even more if there are upfront fees included in the new loan, which is almost always the case. Payment-myopic borrowers don't look down the road.