Partners (Summer 2000)
Partners (Summer 2000)
What is Predatory Lending?
By Wayne Smith
We have all heard of situations where lenders target more-vulnerable borrowers who have significant equity in their home, with the ultimate intention of seizing the property. The borrowers are typically saddled with excessive costs, often clandestinely. The loans are booked based on the equity in a house, not on the income available to repay the loan. Foreclosure becomes inevitable. But is predatory lending always that clear cut? Unfortunately, no.
In order to define predatory lending, one must start with an understanding of subprime lending. “Subprime” refers to lending where borrowers have some form of credit impairment. The term applies to borrowers who do not qualify for the “prime market” and is also known as “B, C, or D paper” — contrasting with the prime market’s “A paper.”
A borrower’s credit history determines his/her credit score as assigned by a credit rating agency. A credit score can be adversely impacted for reasons such as a history of late payments or previous defaults. Whether fair or unfair, such blemishes represent higher risk to a lender in future borrowing requests. To compensate for taking such risks, a lender will typically charge a higher interest rate and/or added fees.
The industry practice of risk-based pricing is nothing new. In fact, it usually represents a positive thing, when done fairly, because it enables a borrower to obtain the credit they may need and work their way back to “A” status. Therefore, responsible subprime lending represents a way for borrowers to maintain access to credit despite past impairment. Where is that line drawn before risk-based pricing goes too far and becomes predatory? There is no magic answer, largely because state and federal laws are rather broad concerning agreements between two parties. Consensus toward a workable definition seems to lie in predatory lending’s attributes — the list of practices that can be considered abusive.
The Typical Borrower
Before discussing abusive practices, it’s appropriate to provide an example of how the predatory process usually begins. The profile of a typical “victim” is an individual (often minority or elderly) in an older home with a legitimate need, such as a new roof. A disproportionate percentage also seems to be African American or Hispanic, although targets are not confined to these groups. Both urban and rural areas are susceptible, and many middle-income populations are targets due to having problems with past credit histories.
With limited cash flow, but with accumulated equity in their home, the borrower is approached by a lender with a loan to repair the roof. Through confusion or fine print, the borrower often finds out after it’s too late that their loan contains added costs that have escalated the monthly payment to the point of unmanageability. Even if suspicion is raised at the time of loan closing, borrowers may go through with the deal because of the overwhelming need as well as the perception that they have no other options.
Having noted the positive aspects of subprime lending and the typical borrowing situation, what exactly makes a loan predatory? The line is usually crossed with a series of practices that have come to be viewed as abusive. A sample of some of the more common adverse practices include the following:
- “Targeting” vulnerable homeowners (e.g. seniors, less-educated) who have substantial home equity;
- Lending on a home’s equity rather than the borrower’s cash flow capacity;
- “Packing” unnecessary items such as high-cost single-premium life and other insurance products on top;
- “Stacking” high origination and other fees that are rolled into the note;
- “Flipping” — frequent refinancings with additional fees that strip equity;
- Requiring a balloon payment after 5 years on a 30-year interest-only note; and
- Imposing an excessive prepayment penalty.
The definition of predatory lending remains rather elusive because of gray areas within each of the adverse practices listed above, and because taken by themselves, they may not be illegal. Misrepresentations, including fraud, are clear cut predatory practices and are illegal. Other practices cross the line as predatory when the basic tenets of safe and sound lending are not upheld, especially with regard to Fair Lending laws and a borrower’s ability to service an obligation out of income.
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