What Is Predatory Lending?
November 8, 1999, revised July 18, 2007
Mortgage lending is predatory when it has a significant adverse impact on a borrower’s life, either because the loan is inappropriate to the borrower’s situation, is grossly over-priced, or both. Most predatory lending is a perversion of a legitimate activity, which is what makes it so difficult to develop remedies that don’t do more harm than good. Counseling directed at potential victims has no capacity for harm, but people can't be compelled to seek counsel, or to listen when they receive it.
If there were no prey, there would be no predators.
Predatory lenders take advantage of borrower weaknesses, which are discussed in more detail in Avoiding Mortgage Predators. These include ignorance about how mortgages work, especially the more complicated ones. Befuddling the borrower is part of the predator’s stock in trade.
Predatory lenders take advantage of borrower shortsightedness. This includes "payment myopia", a common tendency to focus on initial payments, ignoring the possibility of higher future payments. The promise of low initial payments is a principal weapon in the predator’s arsenal.
Borrowers who are payment myopic also tend to be "balance blind". They ignore how much they will owe down the road, which makes it easy for predators to load exorbitant upfront fees into the loan balance. Payment myopic/balance blind borrowers are also the perfect foil for negative amortization ARMs that offer very low initial payments that don’t cover the interest, combined with a rising loan balance.
Borrowers are often "cash dazzled", in that the prospect of putting free cash in their pocket makes them oblivious to how much home equity the cash is costing them. Such borrowers are among the most tempting of all prey to a predator.
Predatory lending should be distinguished from the minor imperfections that pervade the market. A very large proportion of mortgage borrowers pay more for their loans than they would have if they had been able to shop the market effectively. (See What Is an Overage?). In most cases, however, the over-charge is small and life goes on.
In cases of predatory lending, over-charges are offensively large, often associated with steering into inappropriate mortgage types, and sometimes associated with refinances that make the borrower poorer. The result is a significant adverse impact on the borrower’s life.
Here is an incomplete list of some widespread predatory practices.
Borrowers with significant equity in their homes, meaning that their homes are worth more than the debts secured by the homes, are potential targets for predators. Their aim is to shift as much of that equity as possible into their pockets.
In The Cash-Out Refinance Scam I give an example of equity grabbing associated with cash-out refinancing -- refinancing for an amount larger than the balance on the old mortgage. In the example, a borrower with significant equity in his home refinances a zero interest-rate loan into a 14% loan, with heavy fees that are included in the new loan balance. The lender talked the borrower into this by putting cash in the borrower's pocket. But the borrower was saddled with a larger repayment obligation that he couldn't meet, resulting in default.
I hasten to add that the cash-out refinance is a perfectly legitimate tool that has been used successfully by many borrowers. But it can be perverted by a predator dealing with a cash-dazzled borrower.
Gullible homeowners are sometimes sweet-talked into contracting for repairs for which they are overcharged, then the cost of the repairs plus high loan fees are rolled into a mortgage that they may not be able to afford. In many such cases, the borrower defaults and loses the home.
The most commonly used mortgage in the sub-prime market is the 2/28 ARM. This is an adjustable rate mortgage on which the rate is fixed for 2 years, and is then reset to equal the value of a rate index at that time, plus a margin. The upfront charges that make the loan profitable to originate are included in the loan balance.
Because sub-prime margins are high, the rate on most 2/28s will rise sharply at the 2-year mark, even if market rates do not change during the period. The borrower is told that this is not a problem because the loan can be refinanced into another 2/28 at that time. And they are refinanced, assuming there is enough equity left in the house to support the new costs that will be embedded in the loan balance.
This process can continue until the borrower runs out of equity. If house prices stop rising and start declining, many borrowers don’t have the equity to refinance and are unable to meet the mortgage payment at the 2-year rate adjustment mark. The result is a large jump in sub-prime foreclosures, which is what happened in 2007. (See Upheaval in the Sub-Prime Market).
There is nothing inherently wicked about the 2/28 ARM. What makes it a predatory tool is a combination of three factors:
*The high margin, which generates a large payment increase after 2 years in the absence of a refinance.
*High origination fees, which are embedded in the balance to reduce the borrower’s equity.
*Underwriting the borrower’s ability to afford the mortgage at the initial rate.
Many refinances make the borrower worse off rather than better off, see Refinancing That Make Your Poorer. The instrument used most widely by predators in soliciting refinance business is the option ARM, because it allows them to merchandise the very low payment in the first year, which is calculated at rates as low as 1%. Some marketing hype goes so far as to imply that the initial rate, which holds only for the first month, lasts for 5 years. For an example, see See Predators and Victims: A Classic Illustration.
In the typical case, a borrower with a fixed-rate mortgage of 6% is seduced into refinancing into an option ARM in order to enjoy a 40% drop in payment. However, in the second month, the rate on the option ARM jumps to 7.5%, and the borrower finds the loan balance rising every month because the payment does not cover the interest. At some point, the payment jumps markedly and becomes far higher than the earlier payment on the FRM.
Like the 2/28. the option ARM has legitimate uses. It becomes toxic only when it is foisted on gullible borrowers who have no real need for it and would not have chosen it had they understood how it worked. See Questions and Answers About Option ARMs.
Contract knavery involves sneaking provisions into the loan contract that disadvantage the borrower, and for which the lender has provided no quid pro quo. The mortgage process, where borrowers don’t get to see the note until closing, at which point a pile of documents is thrown at them for signature, facilitates contract knavery.
The provision sneaked most often into contracts is a prepayment penalty clause, notwithstanding that the Truth in Lending document received by the borrower shows whether or not there is a penalty. The TIL warning is simple ineffective, for reasons discussed in Disclosure Rules on Mortgage Prepayment Penalties.
Lenders can be prevented from sneaking prepayment penalties into contracts simply by making prepayment penalties illegal, and a number of states have done this. But this prohibition deprives some borrowers of a useful option.
In states that allow prepayment penalties, borrowers who shop can get a 1/4% reduction in the rate if they accept a prepayment penalty. There are many borrowers struggling to qualify who would willingly exchange the right to refinance without penalty in the future for a rate reduction now.
Escalation of settlement fees means that as a loan moves toward closing, the borrower finds that the loan fees for which he is responsible increase. Usually, this is by the addition of fees that had not previously been mentioned. The Good Faith Estimate of Settlement, which loan providers are required to provide borrowers within 3 days of receipt of a loan application, does not protect the borrower against estimates given in bad faith, which is a mark of a predator. See Legal Thievery at the Closing Table.
Escalation of settlement fees is similar to contract knavery in exploiting the weaknesses of the mortgage process. Once the borrower commits to begin the process, it is very costly to back out, especially on purchase loans where the purchaser has a firm closing date to meet.
Price-gouging means charging interest rates and/or fees that are markedly above those the same borrowers could obtain elsewhere had they effectively shopped the market.
While the other types of predatory lending include price gouging, they all have other distinguishing features. Simple price gouging is a recognition that predation can occur on a plain vanilla transaction, such as a purchase transaction financed with a 30-year fixed-rate mortgage.
All that is required for price gouging to occur is for a predatory loan provider to happen on an unsophisticated, reticent and trusting borrower. I have seen such cases, though I don’t think they arise very often. Usually, the predator needs more to work with than the gullibility of the borrower.
Mortgage lending is predatory when it has a significant adverse impact on a borrower’s life, either because the loan is inappropriate to the borrower’s situation, is grossly over-priced, or both. Most predatory lending is a perversion of a legitimate activity, which is what makes it so difficult to develop remedies that don’t do more harm than good. Counseling directed at potential victims has no capacity for harm, but people can't be compelled to seek counsel, or to listen when they receive it.
Predatory Lenders Prey on Borrower Weakness
If there were no prey, there would be no predators.
Predatory lenders take advantage of borrower weaknesses, which are discussed in more detail in Avoiding Mortgage Predators. These include ignorance about how mortgages work, especially the more complicated ones. Befuddling the borrower is part of the predator’s stock in trade.
Predatory lenders take advantage of borrower shortsightedness. This includes "payment myopia", a common tendency to focus on initial payments, ignoring the possibility of higher future payments. The promise of low initial payments is a principal weapon in the predator’s arsenal.
Borrowers who are payment myopic also tend to be "balance blind". They ignore how much they will owe down the road, which makes it easy for predators to load exorbitant upfront fees into the loan balance. Payment myopic/balance blind borrowers are also the perfect foil for negative amortization ARMs that offer very low initial payments that don’t cover the interest, combined with a rising loan balance.
Borrowers are often "cash dazzled", in that the prospect of putting free cash in their pocket makes them oblivious to how much home equity the cash is costing them. Such borrowers are among the most tempting of all prey to a predator.
Predatory lending should be distinguished from the minor imperfections that pervade the market. A very large proportion of mortgage borrowers pay more for their loans than they would have if they had been able to shop the market effectively. (See What Is an Overage?). In most cases, however, the over-charge is small and life goes on.
In cases of predatory lending, over-charges are offensively large, often associated with steering into inappropriate mortgage types, and sometimes associated with refinances that make the borrower poorer. The result is a significant adverse impact on the borrower’s life.
Here is an incomplete list of some widespread predatory practices.
Cash-Out Refinances to Cash-Dazzled Borrowers
Borrowers with significant equity in their homes, meaning that their homes are worth more than the debts secured by the homes, are potential targets for predators. Their aim is to shift as much of that equity as possible into their pockets.
In The Cash-Out Refinance Scam I give an example of equity grabbing associated with cash-out refinancing -- refinancing for an amount larger than the balance on the old mortgage. In the example, a borrower with significant equity in his home refinances a zero interest-rate loan into a 14% loan, with heavy fees that are included in the new loan balance. The lender talked the borrower into this by putting cash in the borrower's pocket. But the borrower was saddled with a larger repayment obligation that he couldn't meet, resulting in default.
I hasten to add that the cash-out refinance is a perfectly legitimate tool that has been used successfully by many borrowers. But it can be perverted by a predator dealing with a cash-dazzled borrower.
Home Improvement Loans for Over-Priced Repairs
Gullible homeowners are sometimes sweet-talked into contracting for repairs for which they are overcharged, then the cost of the repairs plus high loan fees are rolled into a mortgage that they may not be able to afford. In many such cases, the borrower defaults and loses the home.
Successive Refinancings on 2/28 ARMs
The most commonly used mortgage in the sub-prime market is the 2/28 ARM. This is an adjustable rate mortgage on which the rate is fixed for 2 years, and is then reset to equal the value of a rate index at that time, plus a margin. The upfront charges that make the loan profitable to originate are included in the loan balance.
Because sub-prime margins are high, the rate on most 2/28s will rise sharply at the 2-year mark, even if market rates do not change during the period. The borrower is told that this is not a problem because the loan can be refinanced into another 2/28 at that time. And they are refinanced, assuming there is enough equity left in the house to support the new costs that will be embedded in the loan balance.
This process can continue until the borrower runs out of equity. If house prices stop rising and start declining, many borrowers don’t have the equity to refinance and are unable to meet the mortgage payment at the 2-year rate adjustment mark. The result is a large jump in sub-prime foreclosures, which is what happened in 2007. (See Upheaval in the Sub-Prime Market).
There is nothing inherently wicked about the 2/28 ARM. What makes it a predatory tool is a combination of three factors:
*The high margin, which generates a large payment increase after 2 years in the absence of a refinance.
*High origination fees, which are embedded in the balance to reduce the borrower’s equity.
*Underwriting the borrower’s ability to afford the mortgage at the initial rate.
Soliciting Refinances With Option ARMs
Many refinances make the borrower worse off rather than better off, see Refinancing That Make Your Poorer. The instrument used most widely by predators in soliciting refinance business is the option ARM, because it allows them to merchandise the very low payment in the first year, which is calculated at rates as low as 1%. Some marketing hype goes so far as to imply that the initial rate, which holds only for the first month, lasts for 5 years. For an example, see See Predators and Victims: A Classic Illustration.
In the typical case, a borrower with a fixed-rate mortgage of 6% is seduced into refinancing into an option ARM in order to enjoy a 40% drop in payment. However, in the second month, the rate on the option ARM jumps to 7.5%, and the borrower finds the loan balance rising every month because the payment does not cover the interest. At some point, the payment jumps markedly and becomes far higher than the earlier payment on the FRM.
Like the 2/28. the option ARM has legitimate uses. It becomes toxic only when it is foisted on gullible borrowers who have no real need for it and would not have chosen it had they understood how it worked. See Questions and Answers About Option ARMs.
Contract Knavery
Contract knavery involves sneaking provisions into the loan contract that disadvantage the borrower, and for which the lender has provided no quid pro quo. The mortgage process, where borrowers don’t get to see the note until closing, at which point a pile of documents is thrown at them for signature, facilitates contract knavery.
The provision sneaked most often into contracts is a prepayment penalty clause, notwithstanding that the Truth in Lending document received by the borrower shows whether or not there is a penalty. The TIL warning is simple ineffective, for reasons discussed in Disclosure Rules on Mortgage Prepayment Penalties.
Lenders can be prevented from sneaking prepayment penalties into contracts simply by making prepayment penalties illegal, and a number of states have done this. But this prohibition deprives some borrowers of a useful option.
In states that allow prepayment penalties, borrowers who shop can get a 1/4% reduction in the rate if they accept a prepayment penalty. There are many borrowers struggling to qualify who would willingly exchange the right to refinance without penalty in the future for a rate reduction now.
Settlement Fee Escalation
Escalation of settlement fees means that as a loan moves toward closing, the borrower finds that the loan fees for which he is responsible increase. Usually, this is by the addition of fees that had not previously been mentioned. The Good Faith Estimate of Settlement, which loan providers are required to provide borrowers within 3 days of receipt of a loan application, does not protect the borrower against estimates given in bad faith, which is a mark of a predator. See Legal Thievery at the Closing Table.
Escalation of settlement fees is similar to contract knavery in exploiting the weaknesses of the mortgage process. Once the borrower commits to begin the process, it is very costly to back out, especially on purchase loans where the purchaser has a firm closing date to meet.
Simple Price-Gouging
Price-gouging means charging interest rates and/or fees that are markedly above those the same borrowers could obtain elsewhere had they effectively shopped the market.
While the other types of predatory lending include price gouging, they all have other distinguishing features. Simple price gouging is a recognition that predation can occur on a plain vanilla transaction, such as a purchase transaction financed with a 30-year fixed-rate mortgage.
All that is required for price gouging to occur is for a predatory loan provider to happen on an unsophisticated, reticent and trusting borrower. I have seen such cases, though I don’t think they arise very often. Usually, the predator needs more to work with than the gullibility of the borrower.