In its simplest form, the concept of predatory lending includes the imposition of excessive interest rates, origination fees, premiums, penalties, or other oppressive terms in consumer lending transactions. What makes these transactions “predatory” is that the loan terms are not based on the borrower’s credit rating; instead, the lender imposes higher rates or additional charges due to the borrower’s dire financial straits or financial illiteracy. In addition, there are instances of just plain fraud. Predatory lending occurs in consumer lending transactions such as:
- residential mortgage loans
- reverse mortgages
- installment loans
- auto-title loans
- payday loans
- home improvement loans
- rent-to-own contracts
- income tax refund anticipation loans
- long-term car loans.
Although some of the terms do not appear to be particularly high in dollar terms, they can result in exorbitant interest rates. For example, a payday loan fee of $2 for every $20 borrowed, based on a 30-day repayment period, would amount to an annual interest rate of 120%.
The following terms describe various tactics used by predatory lenders that essentially result in “equity stripping,” which means that, as a result of these charges, the borrower’s equity in the collateral, whether a residence or vehicle, is quickly reduced to nothing:
- Packing: The inclusion of unnecessary services, such as prepaid insurance products in the loan amount.
- Unbundling: Separately itemizing charges that should be included within other services.
- Steering: Pricing a loan that is not truly risk-based. Through steering, the borrower is convinced to execute a promissory note with an interest rate higher than is warranted by his/her credit rating. Steering is estimated to occur in 10-50% of sub-prime loans.
- Rent-seeking: The inclusion of unexplained interest rate premiums over and above what borrowers in the sub-prime market pay. This amounts to a marked difference between market rate and the best sub-prime rate. These high loan fees can range from 10-20% of the principal amount, as opposed to 0-2% in prime loans, and include prepayment penalties (generally found in 80% of sub-prime loans but in only 2% of prime market loans).
- Self-Feeding: When origination fees are financed, they become self-feeding, i.e., these fees and charges increase the principal balance of the loan, upon which the high interest rate already applies, thereby magnifying the loan rate and increasing the payments.
- Flipping: Lenders buy and quickly re-sell loans with repeated refinancing and related new costs and fees each time. Redlining: The lender’s exclusion of borrowers from potential credit-based consideration because of geographical determinations rather than based on specific lending criteria.
- YSP – Yield Spread Premiums: A bonus the lender pays to the broker as a reward for getting the borrower to agree to a higher interest rate than the predetermined par rate — the rate based on the borrower’s risk factors. The YSP is the spread between the par rate and the actual note rate. Only the broker and the lender know the par rate. YSP’s must be disclosed under the Federal Real Estate Settlement Procedures Act, but the notation is so abbreviated on HUD1 forms that it can be easily overlooked by an unsophisticated borrower.
The elderly are most likely to be hit with predatory lending scams for home improvement or reverse mortgages. Residents of economically depressed areas are prone to fee gouging for payday loans, rent-to-own contracts, and income tax refunds. Minorities and newer immigrants are targets for unscrupulous mortgage brokers for “sub-prime” mortgage or installment loans. The sub-prime market consists of borrowers with either no credit history or a tarnished credit history, such as new immigrants. In the subprime market, interest rates and fees are much higher than in “prime markets” — conventional lending sources to borrowers with acceptable credit scores.
Several federal and state statutes are designed to prevent these abusive practices. Attorneys General around the country, including Ohio’s Marc Dann, have sued numerous lenders for violating lending laws. In reality, however, the cure for predatory lending is not litigation, but rather changing the manner in which high-risk borrowers obtain credit. One suggestion is to require mortgage brokers to affirm their loyalty to borrowers, in the same manner a real estate brokers are required to affirm their loyalty to purchasers. Other approaches can originate the grass-roots level, such as: (1) expanding the Community Reinvestment Act and encouraging or requiring CRA lenders to expand their lending areas and avoid redlining; (2) pre-credit counseling for borrowers; and, (3) financial literacy education in targeted areas and communities. Several local and national organizations have assistance programs, including Legal Aid, The Home Ownership Center, AARP, and the Association of Community Organizations for Reform Now (ACORN. ORG). Borrowers who have questions about whether they have been victimized by predatory lending can contact the Attorney General’s office, any of these agencies, or legal counsel.
Philomena Ashdown is a member of Strauss & Troy’s Business Law Department, with an emphasis on creditors’ rights, workouts, and bankruptcy. For more information, she can be reached at (513) 621-2120.