Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
Predatory lending consists of a number of practices that exploit consumers and can result in the loss of homes and life savings. Predatory lending includes both technically legal, but high cost, loans and outright fraud through deceptive lending practices. A common element of all predatory loans is exploiting a consumer’s ability to repay. Borrowers are often lent amounts far in excess of what their incomes can support. Another characteristic of predatory loans is interest rates and fees that are well in excess of what is needed by a lender to compensate for risk and earn a reasonable profit.
A key characteristic of predatory loans is their prey, or target consumer. Predatory lenders aggressively market to vulnerable groups. They often capitalize on the desperation of homeowners who need money immediately and can’t wait, or can’t qualify, for a traditional bank loan. Elderly and minority consumers and immigrants with poor language and literacy skills are frequent targets of predatory lenders.
A common “red flag” of predatory loans is a high debt service-to-income ratio. In other words, borrowers are allowed – even encouraged – to borrow more than they can afford. Predatory lenders don’t care if borrowers can’t keep up with the monthly payments. As soon as borrowers can’t pay what is owed, the lender will encourage them to refinance or will simply foreclose, taking away a person’s house and the home equity they have spent years building.
Predatory lenders try to hook borrowers with the promise of low monthly payments. Some use telephone and door-to-door solicitations in “targeted” neighborhoods, as well as direct mail, fliers, and the Internet. Of course, the reason predatory loan payments seem so low is that the term of the loan is extended, sometimes for decades. Monthly payments for loans stretched out over 20 years will always be less expensive than loans that take five years to repay. The total cost, of course, is another matter.
A third “red flag” of predatory loans is a high loan-to-value (LTV) ratio. A loan-to-value ratio is calculated by dividing the amount of a mortgage loan by the value of the home that is being used as security for the loan. For example, a $75,000 loan on a $100,000 home would have an LTV ratio of .75 (75%). Loan-to-value ratios on typical mortgage loans are typically 80% of the appraised value of a house, or less. Predatory lenders often lend 100%, and sometimes more, of a home’s appraised value, often by using phony appraisals to inflate the value of the home being used as collateral.
Not all predatory loans involve houses and home equity. In fact, some of the worst offenders, in terms of predatory practices, are not mortgage lenders at all but, rather, non-mortgage consumer lenders. Some examples are payday loans, car title loans, pawnshop loans, and rent-to-own plans. Payday loans are single-payment, short-term loans that are made in return for delayed deposit of a borrower’s personal check. These loans go by a variety of names that indicate that borrowers are receiving cash in advance of a future paycheck, including cash advance loans, check advance loans, paycheck loans, post-dated check loans, deferred deposit check loans, and quick cash loans.
Here’s how payday loans work. A borrower writes a postdated personal check to the lender, typically for a sum between $100 and $500. Payday loan fees can seem “cheap” at first but, in reality, they are a very expensive way to borrow money when the amount of the fee is considered in relation to the short two-week length of the loan. To fully understand the high cost of payday loans, in relation to other forms of borrowing (e.g., credit cards, bank loans), it is necessary to convert the cost into an annual percentage rate or APR. An APR is the simple percentage cost of all finance charges over the life of a loan on an annual basis. The annual percentage rate for paying $15 to borrow $100 for two weeks is 390% (15% biweekly x 26 biweekly periods in a year = a 390% APR). What happens with payday loans after two weeks? Depending on the lender, borrowers can “redeem” the postdated check with $115 cash or have the lender simply deposit it (assuming there are adequate funds in the borrower’s checking account). Unfortunately, many borrowers don’t have enough money to repay the lender after two weeks. Perhaps they were behind on other bills or had some type of emergency. A second option is to extend the payday loan with another fee (e.g., another $15 for the same $100 loan).
An extended payday loan is called a rollover. After a few rollovers, the fee charged for payday loans can actually exceed the amount borrowed. Many people don’t pay off these loans for months and, therefore, dig themselves deep into debt. If you extend a $100 loan three times (i.e., three more bi-weekly periods), you will have paid $60 to borrow $100: the original $15 fee plus $45 for three more extensions ($15 x 3). After six rollovers the finance charge (fees) will be greater than the amount borrowed. Not surprisingly, many states have passed laws that limit the number of times that payday loans can be rolled over.
The word “interest” is generally not used in payday lending agreements. Instead, payday lenders call their charges “fees.” This way they don’t violate state usury laws which cap the amount of interest that can be charged on loans. In some states, lawmakers exempt payday lenders from limits on interest rates. Payday loan fees are exactly like interest charged on a credit card, except much higher. With all types of loans or credit, consumers pay a price to borrow money.
Even more dangerous and alarming than payday loans are a similar type of loan (i.e., quick cash without a credit check) called a car title loan. Borrowers hand over the title (and registration and a key) to their car in order to borrow money. They get to keep their car and drive it but, if they don’t repay the loan, the lender repossesses the car, sells it, and keeps whatever the car sells for. Car title loans work much like pawnshop loans, where an item of value is held as security for a loan. The difference is that car title loan borrowers can keep driving their car while pawned items are generally unavailable for a borrower’s use.
Here is an example. Let’s say your car is worth $2,500 and you owe the lender $1,000. The lender repossesses your car and sells it for $2,500. In this case, the lender would walk away with a $1,500 profit and the borrower will have lost all of the equity (car value minus amount owed) in the vehicle plus have no transportation for work or personal business. Car title loans are very risky. Title lenders know where borrowers live and work and can easily repossess a car, drive it to an auction, and sell it.
Rent-to-Own (RTO) agreements consist of a rental contract renewed on a weekly or monthly basis. Usually, the terms are for 78 weeks (18 months). The customer has the choice at the end of the rental period of whether to renew the item or return it to the store. If the customer chooses to renew the “lease”, he or she simply makes the next payment. Almost anything you want can be “purchased” at a typical RTO store including electronic and computer equipment, household appliances, furniture, and jewelry.
The potential benefits of purchasing from a RTO store are generally far outweighed by the realities of the situation. Purchasing goods from a RTO is an expensive method of ownership and items usually end up costing 3 to 4 times the retail value. For example, if someone pays $19 a week for a television that costs $500 retail, after 18 months they would have paid $1,482 (78 x $19), or almost enough for 3 sets.
Becoming an informed consumer is the best protection against predatory lending practices. Unfortunately, many predatory lenders harm consumers before government regulators can close them down. By the time they are caught, damage has already been done. The best way to avoid predatory lenders is to understand how they operate. As in many life situations, “knowledge is power.” Walk away from any lender that encourages you to borrow more than you need, requires life insurance, has loans with balloon payments coming due in under 10 years, charges excessively high costs, doesn’t answer all of your questions, and provides a blank contract with spaces “to be filled in later.” Never sign a loan contract you don’t understand and always check that terms that were told to you orally are the same in the loan contract.
