What Is Predatory Lending?
Predatory lending typically means imposing unfair, deceptive, or 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 lender's benefit.
Predatory lenders often use aggressive sales tactics and exploit borrowers’ lack of understanding of financial transactions. Through deceptive or fraudulent actions and a lack of transparency, they entice, induce, and assist a borrower in taking out a loan they will not reasonably be able to pay back.
Key Takeaways
- Predatory lending is any lending practice that imposes unfair and abusive loan terms on borrowers.
- Some aspects of predatory lending include high-interest rates, high fees, and terms that strip the borrower of equity.
- The economic impact of COVID-19 gave way for cash-strapped consumers to become vulnerable to predatory loans.
- Predatory lending disproportionately affects women, Black, and Latinx communities.
- Predatory lending often occurs in conjunction withhome mortgages.
How Predatory Lending Works
Predatory lending includes any unscrupulous practices carried out by lenders to entice, induce, mislead, and assist borrowers toward taking out loans they are unable to pay back reasonably or must pay back at a cost that is extremely above the market rate. Predatory lenders take advantage of borrowers' circ*mstances or lack of knowledge.
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. However, a great deal of predatory lending is carried out by more established institutions like banks, finance companies, mortgage brokers, attorneys, or real estate contractors.
Predatory lending puts many borrowers at risk, but it primarily 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, those with less access to education, or those subject to discriminatory lending practices because of their race, ethnicity, age, or disability.
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 and generally use a variety of unfair and deceptive tactics to profit.
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. These tactics can include those identified by the Federal Deposit Insurance Corporation (FDIC), along with several others:
- Excessive and abusive fees:These are often disguised or downplayed because they are not included in a loan's interest rate. According to the FDIC, fees totaling more than 5% of the loan amount are not uncommon. Excessive prepayment penalties are another example.
- Balloon payment: This is one substantial 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, incur 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, say a home or a car, rather than on your ability to repay the loan. You risk losing your home or car when you fall behind on payments. Equity-rich, cash-poor older adults on fixed incomes may be targeted with loans (say, for a house repair) that they will have difficulty repaying and that will jeopardize their equity in their home.
- Unnecessary add-on products or services, such as single-premium 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 are still largely inhabited by Black and Latinx communities. And in a kind of reverse redlining, they are often targeted by predatory and subprime lenders.
Common Types of Predatory Loans
Subprime Mortgages
Classic predatory lending centers aroundhome mortgages. Because 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 tremendous financial burden it represents. With the explosive growth of subprime loans came the potential for predatory lending.
When the housing market crashed, and a foreclosure crisis precipitated theGreat Recession, homeowners with subprime mortgages became vulnerable. Subprime loans came to represent a disproportionate percentage of residential foreclosures. Black and Latinx homeowners were particularly affected.
Predatory Lenders
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 like loan-to-value (LTV) ratios, subordinate liens, and debt-to-income (DTI) ratios, data shows that Black and Latinx borrowers were more likely to receive subprime loans at higher costs.
Women, too, were targeted during the housing boom that crashed spectacularly in 2008, regardless of their income or credit rating. Black women with the highest incomes were five times more likely than White men of similar incomes to receive subprime loans.
Predatory lenders typically target vulnerable populations, such as those struggling to meet monthly expenses, people who have recently lost their jobs, and those whoare deniedaccess to a wider range of credit options for illegal reasons, such as discrimination based on a lack of education or older age.
Settlements
In 2012, Wells Fargo reached a $175 billion settlement with the Justice Department to compensate Black and Latinx borrowers who qualified for loans and were charged higher fees or rates or 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 also climbed back up, contributing yet again to the racial wealth gap.
In October 2021, the Federal Reserve revealed that the average Black and Hispanic or Latino households earn about half as much as the average White householdand own only about 15% to 20% as much net wealth.
Payday Loans
Thepayday loanindustry lendsbillions of dollars annually in small-dollar,high-cost loans as a bridgetothe next payday. These loans typically are for two weeks, with annual percentage rates (APR) ranging from 390% to 780%. Payday lenders operateonline and through storefronts largely in financially underserved—and disproportionately Black and Latinx—neighborhoods.
Although the federal Truth in Lending Act (TILA) requires payday lenders to disclose their finance charges, many people overlook the costs. Most loans are for 30 days or less and help borrowers to meet short-term liabilities. Loan amounts on these loans are usually from $100 to $1,000, with $500 being common. The loans usually can be rolled over for additional finance charges, and many borrowers—as high as 80% of them—end up as repeat customers.
With new feesadded 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. A number of court cases have been filed against payday lenders, as lending laws have been enacted since the 2008 financial crisis to create a more transparent and fair lending market for consumers. However, research suggests that the market for payday loans has only expanded since 2008 and that it enjoyed a boom during the 2020–2022 COVID-19 pandemic.
If a lender tries to rush you through the approval process, doesn't answer your questions, or suggests you borrow more money than you can afford, you should be wary.
Auto-Title Loans
These are single-payment loans based on a percentage of your car's value. They carry high-interest rates and a requirement to hand over the vehicle's title and a spare set of keys as collateral. For the roughly 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 childcare 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 that the platform extended to its 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 escape.
Is Anything Being Done About Predatory Lending?
To protect consumers, many states have anti-predatory lending laws. Some states have outlawed payday lending altogether, while others have put caps on the amount lenders can charge.
The U.S. Department of Housing and Urban Development (HUD) and the Consumer Financial Protection Bureau (CFPB) have also taken measures to combat predatory lending. However, as the shifting stance of the latter agency shows, rules and protections are subject to change.
In June 2016, the CFPB issued a final rule establishing stricter regulations for the underwriting of payday and auto-title loans. Then, under new leadership in July 2020, the 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 for protecting yourself when you take on a mortgage, including instructions for canceling private mortgage insurance (PMI), which a borrow might be required to pay to their lender. HUD also advises on mortgages and CFPB offers guidance on payday loans.
- Shop around for your loan before you sign on the dotted line. If you've experienced lending discrimination in the past, you'll understandably just want to get the process over with as soon as possible. Don't let the lenders win this time. Comparing offers will give you an 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.
What Is an Example of Predatory Lending?
Whenever a lender seeks to take advantage of a borrower and tie them to unfair or unmanageable loan terms, it can be considered predatory lending.Telling signs of a predatory lender include aggressive solicitations, excessive borrowing costs, high prepayment penalties, big balloon payments, and being encouraged to consistently flip loans.
Is Predatory Lending a Crime?
In theory, yes. If you are enticed and misled into taking out a loan that carries higher fees than your risk profile warrants or that you are unlikely to be able to pay back, you have potentially been the victim of a crime. There are laws in place to protect consumers against predatory lending, though plenty of lenders continue to get away with it, partly because consumers don’t know their rights.
Can I Sue for Predatory Lending?
If you can prove that your lender violated local or federal laws, including the Truth in Lending Act (TILA), you may want to consider filing a lawsuit. It’s never easy going against a wealthy financial institution. However, if you have proof that this lender broke rules, you have a reasonable chance of being compensated. As a first step, contact your state consumer protection agency.
The Bottom Line
Predatory lending is any lending practice 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 out loans they can't afford. And in many cases, predatory lenders have targeted vulnerable populations.
Predatory lenders aren't all loan sharks. A great deal of predatory lending is carried out by more established institutions. The subprime mortgage boom in the years leading up to 2008 was, arguably, an example of predatory lending.
Education and research are crucial to avoiding predatory loans. Make sure you understand any loan documents you are signing and calculate how much you'll owe.
