What Is a Predatory Loan?
Definition & Examples of Predatory Loans
Predatory loans manipulate borrowers into accepting payment terms that are exploitative. They're used by unscrupulous lenders to extract more money than the borrower has the ability to repay, often through high interest rates or fees they never expected.
Understand how a predatory loan works and identify common predatory loans and their telltale signs and alternatives to avoid falling victim to them.
What Is a Predatory Loan?
A predatory loan can be just about any type of loan that gives the upper hand to the lender and stiffs the borrower out of their money through unfair or excessive lending terms. These terms can include unusually high interest rates, fees and penalties, insurance, and other extra costs, or a payment plan that causes a borrower's periodic payments or loan balance to increase over time.
While the specific terms vary by the loan and lender, predatory loans are generally pushed through misleading mail, phone, TV, or door-to-door sales tactics known as "predatory-lending" practices. These are aggressive, bait-and-switch tactics that lenders, real estate brokers, contractors, or even lawyers knowingly engage in to lead borrowers into a transaction they didn't expect or agree to and can't afford.
Predatory lending is pervasive across the U.S., but the most common targets for predatory loans are the low-income, the low-credit, the elderly, minorities, and other groups who may otherwise be unable to obtain traditional mortgage loans, auto loans, personal loans, and other consumer loans as a result of their financial situations.
How Predatory Loans Work
A typical predatory loan benefits the lender at the expense of the borrower.
Imagine that you're on the hunt for a home but can't qualify for a traditional mortgage because your outstanding debt has put a dent in your credit score. You're contacted by phone several times by a predatory lender offering you a home loan based on the equity built up in the home rather than your ability to repay the loan.
Desperate for a home, you take the bite and go through the loan proceedings unaware of the fact that the loan is designed to allow the disreputable lender to seize your equity in the home. At the advice of the lender, you even inflate your income during the loan application in order to qualify for it. You later determine that you can't afford the monthly payments. Eventually, you're forced to default on the loan and foreclose on the property. The end result is that you lose the home, whereas the lender doesn't suffer losses since the home value exceeds the loan amount when the home is sold in foreclosure proceedings.
This is a predatory mortgage loan granted through "equity stripping," one of many classic predatory-lending schemes.
While predatory loans generally make your financial life worse, predatory mortgage loans can be particularly devastating because you could lose your home if you default as a result of unaffordable payments.
Types of Predatory Loans
These fraudulent loans can take several forms, but below are some of the most common ones:
- Flipping: This is a loan arrangement whereby a lender offers to refinance a high-rate or otherwise high-cost loan (often a mortgage) at a slightly lower interest rate, usually within just a year of obtaining the original loan. But once you account for loan origination fees and broker fees, points, and closing costs, you actually increase your debt with such a loan.
- Balloon payments: Beware if a mortgage lender tries to sell you a loan wherein your payments are low at first, but then a large payment is due at the end of the mortgage. This large payment is a balloon payment, and this type of mortgage loan is often offered by predatory lenders.
- Negative amortization: Negative amortization is a predatory loan payment structure whereby the borrower pays less than the interest cost every month. The lender then adds the remaining interest cost to your loan balance. For as long as you practice negative amortization, your loan balance grows.
- Packing: Packing occurs when a lender pushes a service (credit insurance, for example) the borrower doesn't need in order to pad the loan balance with unnecessary fees.
- Payday loans: Payday loans are short-term loans due on your next payday. They're dangerous because the financing charges on these loans are so high that the annual percentage rate can sometimes amount to three digits. If you default on a payday loan, your credit score can be impacted for years.
- Title loans: Title loans are short-term, high-interest predatory loans that use collateral (your car, for example) to secure the loan. A car title loan results in you giving the title of your car to a lender and receiving cash in return for it. If you don’t repay the loan in full according to the terms, the lender can repossess your car.
How to Avoid Predatory Loans
Predatory lenders are normally fast and slick talkers. But there are some simple ways to avoid them:
- Recognize the signs of a bad loan: High interest rates, fees, and penalties, repeated communications, and other high-pressure sales methods are telltale signs that a predatory lending scheme is at hand and it's time to walk away.
- Read the fine print: Predatory lenders are rarely upfront about rates, fees, and other loan terms, so carefully read the terms of the loan contract, understand your financial obligations (including the origination fee, prepayment penalty, and any closing costs), and reject any loan you can't afford. Consult a lawyer if you can't determine whether a loan is above board.
- Report suspicious loans: File a complaint with the Consumer Financial Protection Bureau if you suspect that you have been offered a predatory loan.
Heed any gut feelings that something is wrong with the lender and the loan. If the loan seems too good to be true, it likely is.
Alternatives to Predatory Loans
Instead of getting a predatory loan, consider one of these options:
- Bank or credit union: Start with a traditional lender like a well-reviewed bank or local credit union; don't assume they will reject your loan application. Credit unions even offer payday alternative loans (PALs), which are short-term, small-dollar loans that are particularly useful for those who need quick infusions of cash. They also tend to offer lower interest rates on loans than banks.
- Peer-to-peer (P2P) loans: P2P loans are another option you might consider if you have a problem getting a loan from a bank or a credit union. These are loans that investors with extra money make to individuals in the online marketplace, even those with a spotty credit history.
- Family loans: Consider reaching out to a close family member to inquire about getting a small loan. But use a written loan agreement to ensure everyone is one the same page and to avoid souring the relationship.
- Predatory loans convince borrowers through misleading tactics to accept money at unexpected or unaffordable terms.
- Flipping, packing, and negative amortization are a few common predatory-lending schemes.
- Reading the fine print and steering clear of unreasonable rates or fees can help borrowers avoid predatory loans, as can borrowing from traditional lenders.