Money Health

Access to Credit: Predatory Lending and Payday Loans

Predatory Lending
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As our contribution to the ongoing discussion America is having around racial inequality, here is another post in our Financial Discrimination, Access, and Equality series. We will continue to share information about how to recognize and help combat financial discrimination, so please come back to read future posts.

There are times in life where an unexpected financial hardship strikes at exactly the worst time. Maybe your boss cuts your hours at work or your car needs expensive maintenance—your budget is blown, but the rent is still due and you’re already at or near your limit on your credit cards. In times like these, if you don’t have any savings to pull from, what are your options?

If you live in an economically depressed neighborhood, your options could be limited to payday lenders, which offer fast cash, but often at a steep cost. A loan from a payday lender may help you make rent this month, but the sky-high interest rate they’ll charge will add to your debt and may make it even more difficult to pay all your expenses next month. For many consumers, these and other fast-cash arrangements considered predatory may seem like the only option.

What is predatory lending, exactly? In general, the term describes the various tactics used to exploit mainly low-income borrowers with terms that do not benefit them in the long-term. Some payday loans may be exploitative, but not all are considered predatory. Just about all, however, can trap borrowers in cycles of debt.

Exploitative and predatory lending practices prey not only on the financially desperate, but also tend to hurt minority communities that have already endured generations of financial discrimination. Redlining, in particular, resulted in segregated neighborhoods with a lack of banking services, factors that continue to contribute to the racial wealth gap in the United States today.

While generational inequity won’t be solved overnight, this post aims to help readers better understand exploitative and predatory financial practices, and how to avoid them. We’ll discuss what predatory lending is, why payday loans are bad for your financial health, how predatory lenders target communities of color, and what you can do to help protect yourself from these problematic financial products and services.

What is predatory lending?

Just as it sounds, the term predatory lending describes certain lending practices that prey on those who are vulnerable due to insufficient options or a lack of financial knowledge necessary to understand the often complex terms of the loan. This does not mean that those who fall prey to predatory lenders are unsophisticated. Many borrowers know exactly what they’re getting into, but believe they have no other options. Others are simply misled or defrauded.

While predatory lending practices generally target underbanked minority neighborhoods, that’s not always the case. Even minority customers who have better options, regardless of where they live, are routinely steered toward exploitative (or more expensive) loans just by virtue of demographics.

There is no overarching legal definition for predatory lending, and laws differ by state, but the Federal Deposit Insurance Corporation (FDIC) defines it as “imposing unfair and abusive loan terms on borrowers.”

Here, the term “predatory” is used to describe both legal and illegal activities (which vary according to state laws) that are often considered exploitative in nature. For instance, many payday lenders, check-cashing companies, and traditional banks still employ tactics that, while legal, are not beneficial to the consumer. Whether they’re illegal or just have the potential to exploit borrowers, common predatory lending tactics include:

Subprime mortgage loans

Many homebuyers who can’t qualify for a prime loan can qualify for a subprime (or “nonprime”) mortgage, even with credit scores as low as 500 and with very little or no down payment. While these loans may substantially lower the bar to homeownership, they typically come with very high interest rates that reset periodically, if they’re of the adjustable rate (ARM) variety.

Creating this easier path to home ownership can make it harder to understand the total cost of the loan. This could cause some borrowers to purchase more home than they can actually afford, which puts them at risk of default, foreclosure, or other financial stress. Nevertheless, these loans are legal as long as lenders state the terms, don’t discriminate on the basis of race or other such characteristics, and don’t approve borrowers who likely can’t repay the loan.

Even when controlled for income, race plays a major role in the issuance of subprime loans. Research from 2008 shows that 54 percent of high-income African Americans and 49 percent of high-income Latinos were issued subprime loans, compared to 16 percent of high-income white borrowers. Packaged together into mortgage-backed securities (MBSs), some investors found ways to profit when borrowers defaulted on their loans, thus providing an incentive to sell mortgages to as many vulnerable borrowers as possible.

Loans sold by focusing solely on monthly payments

If you’re only looking at your monthly payments, then you’re not considering the big picture. Predatory lenders often gloss over or ignore the other terms of a loan and instead focus solely on touting low monthly payments. But low payments may mask excessive interest rates, the unnecessarily long life of the loan due to low payments, and the overall cost of the loan.

Balloon payment loans

Instead of making a large down payment when signing for a loan, certain lenders may suggest a “balloon” loan requiring the borrower to settle up at the end of the term, which might not be for five to seven years. Again, lenders often emphasize lower monthly payments and interest rates, but minimize the risk of having to make that balloon payment at the end of the term.

Lenders who fail to fully explain the risks of balloon loans are hoping to lure borrowers with their low initial cost. Meanwhile, borrowers may anticipate or simply hope they’ll have a much higher income by the time they need to cut a check for that balloon payment, which could be tens of thousands of dollars or more. If they fail to make the balloon payment, they may lose the asset they purchased, like a house or a car.

Negative amortization loans

Borrowing money costs money, and you pay for the opportunity to borrow by paying interest on top of the loan payments. If your monthly loan payments don’t include the cost of the interest, you’ll never pay off the loan. This is the concept behind negative amortization loans (“amortize” means pay off the loan). These loans have low monthly payments, but the balance will actually go up each month because you’re not paying the full amount of interest, let alone the principal amount you borrowed. Instead, you’re getting deeper and deeper into debt.

Loans that result in a negative amortization, at least temporarily, aren’t necessarily illegal, or even considered predatory. For instance, your student loans may negatively amortize while you’re in school and not making monthly payments. However, the FDIC considers loans where the borrower is unable to determine how much they need to pay in order to amortize the loan, predatory.

Packing

The practice of “packing” loans refers to the addition of fees, charges, and penalties, usually found in the fine print. These terms may not be discussed with the borrower, in hopes that they will sign the loan papers without fully realizing the impact of these additional fees. One common way unscrupulous lenders pack a loan is to add a fee for loan insurance, which in many cases is unnecessary.

Unless you’re a financial advisor, attorney, or have specific knowledge about these tactics, it may be difficult to know whether you really need a particular add-on like loan insurance.

Why payday loans are bad for your financial health

Payday loans are one of the most common types of predatory loans and, although legal, employ many of the tactics described above. Most states allow payday loans, with 37 states specifically addressing them in their statutes, and six states expressly prohibiting them. Primarily located in financially depressed (often minority) communities, payday loans target financially desperate individuals who need fast cash.

Even if you don’t see payday lenders where you live, they are a constant presence in many communities where traditional banking resources are scarce. There were 13,348 payday lenders in the U.S. in 2017, according to the Federal Reserve Bank of St. Louis. This was about the same number of Starbucks locations, at the time.

Payday loans average $375 and come due when the borrower gets their next paycheck, usually two to six weeks. They are typically paid through a balloon payment which includes the principal loan amount, interest, and fees. These loans charge an average of $15 per $100 borrowed, which equates to a 400 percent annual rate for a two-week loan. If you’re unable to pay off your loan on the assigned date, you may be offered a “rollover” for an additional fee. Payday lenders may also pack the loan with additional fees and, if the loan is put onto a payment card, there may also be transaction or cash-advance fees.

The average fee for a two-week payday loan is $55, according to the St. Louis Federal Reserve Bank, but the typical $375 payday loan incurs total fees of $520 because of repeat borrowing. Payday lenders are required to disclose the total cost of the loan before the agreement is signed, but this may be overlooked when borrowers are desperate to cover the rent or feed their families.

How to protect yourself from predatory lending

These lenders target vulnerable borrowers, regardless of race, so what is predatory lending’s specific impact on racial minorities? As noted above, people of color are routinely offered more expensive loans than white borrowers with similar financial profiles. In addition, predatory and payday lenders typically set up shop in minority neighborhoods that have a history of economic hardship. It’s important to understand both the indirect and direct forms of financial discrimination and exploitation.

So, what can all borrowers do to avoid predatory or exploitive traditional lenders? Here are some tips:

  • If you feel pressured, walk away. Whether you’re applying for a mortgage or a smaller loan, you should not feel pressured to accept the terms. High-pressure tactics are a red flag that the loan may not be in your best interest.
  • Do not sign blank documents. Predatory lenders may try to convince you that they need your signature for terms that are yet to be finalized, but you should never sign a blank document.
  • Do not make false statements. Since predatory lenders may offer loans they know you can’t repay, they may encourage you to make inaccurate statements about your income or assets. Doing so could expose you to legal liability and prevent you from taking appropriate legal action against the lender if you need to.
  • Mind your credit score. If the lender suggests that your credit score isn’t a big deal, that should raise a red flag. It’s always important, and you should take steps to build and protect your credit score.
  • Look into online options. Since online financial institutions don’t have brick and mortar locations, they’re often more nimble and able to offer better terms. For example, Chime offers many of the same services as payday lenders, but with more favorable terms.
  • Remember legal protections for military service members. The Military Lending Act prohibits loan rollovers and interest rates greater than 36 percent, and provides some additional protections for military service members and their families.

Above all, take the time to really understand what you’re getting into. Take the documents home with you and do your research. Make sure you know how much the loan will actually cost and be realistic about your ability to satisfy its terms. If you can answer the question, “what is predatory lending?” that may help you spot (and avoid) loans designed to be a debt trap.

Spot the signs of predatory lending and borrow with dignity

While we don’t have a one-size-fits-all solution to financial discrimination, Freedom Debt Relief is dedicated to doing our part to help educate and empower consumers. We will continue to provide information about financial challenges, including the dangers of predatory lenders and payday loans, so you can better plan for your financial future. Come back to our blogs for additional updates and information about this and other important topics.

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Steve Tanner is a veteran writer and editor with experience covering topics from law, to business, technology, and finance. He started his career as a business and technology reporter in Silicon Valley and helped lead the direction of several publications, both print and online. His work has been published in Red Herring, San Jose Business Journal, SFGate.com, and FindLaw.com, among others.