How Predatory Lending Works

Predatory lending is any misleading or dishonest lending practice that targets uninformed homebuyers or borrowers with poor credit. Minorities, nonnative English speakers and the elderly are some of the most popular targets for dishonest lenders. Predatory lenders might automatically charge a higher interest rate to a minority applicant, without regard for his or her credit history. More than half of refinance loans in predominantly black neighborhoods are subprime loans, compared to only 9 percent in white neighborhoods [source: Center for Responsible Lending].

Predatory lenders will use all kinds of pressure tactics to convince a homebuyer to sign. They might tell a borrower that this is his or her only chance to get a mortgage, that there's no one else in town who will give the buyer such a good deal, and that it will be gone tomorrow.

Sometimes a mortgage broker will collude with a certain mortgage lender and get a kickback if the victim signs a mortgage with an inflated interest rate. Or two lenders will run a bait-and-switch operation in which one lender baits a borrower with a highly attractive mortgage offer, but says it fell through at the last second. The second lender calls the same day with a less attractive offer, but capitalizes on the borrower's excitement to buy the house.

Sometimes a predatory lender will convince a homeowner to refinance his or her mortgage without any real financial benefit to the customer [source: U.S. Department of Housing and Urban Development]. The goal for the lender is to trick the homeowner into refinancing for a higher interest rate, or simply to collect any fees associated with the transaction. That's called flipping a loan.

A favorite tactic of predatory lending is to add in mysterious and excessive fees, service charges and unnecessary insurance policies that inflate the cost of a loan. Many people don't read the fine print of their mortgages, or assume that any service charges on their policy are standard. Some predatory loans carry fees that amount to more than 5 percent of the total loan [source: Center for Responsible Lending].

Up to 80 percent of all subprime loans carry something called a prepayment penalty [source: Center for Responsible Lending]. This is a fee that's charged if a borrower pays back too much of his mortgage too soon. While not illegal, this penalty traps borrowers into high-interest mortgages, even if their credit improves enough to qualify for a lower-interest refinancing.

The most blatantly illegal predatory lending tactic is loan fraud. With loan fraud, the lender lies about or conceals important information about the terms of a mortgage. He or she might quote one interest rate verbally, but write a much higher rate in the contract. Or the lender might encourage an applicant to lie about his or her salary or to sign documents with incomplete or incorrect information.

So what are the effects of predatory lending on individuals and on the overall economy? Read on to find out.

The result of predatory lending has been devastating, not only for the individual families, but for the entire United States economy. One in five subprime loans made during 2005 and 2006 will end in foreclosure [source: Center for Responsible Lending]. Foreclosures pull down the value of homes around them, robbing whole neighborhoods of crucial home equity and fueling the already catastrophic housing crisis.

The main problem with predatory lending is that its effects aren't felt immediately. It can take three or four years for a borrower to realize that he or she can't afford a mortgage. That's because the borrower has been tricked into signing up for a so-called "exploding" mortgage. This is an adjustable rate mortgage (ARM) whose interest rate jumps from around 7 percent to as high as 12 percent after the second or third year of the loan. Exploding ARMs are also called "2/28" and "3/27" ARMS because the first two or three years carry a fixed interest rate, and the next 28 or 27 years of the mortgage carry a floating rate.

Why would anyone sign up for such a loan? Because the initial fixed rate, or teaser rate, is below the prime interest rate. And because the lender or mortgage broker convinces the borrower that within those first two years he can improve his credit score and refinance for a fixed interest rate before the adjustable rate resets, or "explodes" [source: Bair].

Part of the argument is that the house itself will grow in equity, allowing the borrower to take out a home equity loan to cover ballooning mortgage payments. But what happens when the housing market starts to drop? People actually lose equity in their homes and end up with nothing to help pay those skyrocketing mortgage payments.

According to a 2007 report by the Congressional Joint Economic Committee, 1.8 million subprime loans are going to reset during 2007 and 2008 [source: U.S. Congress Joint Economic Committee]. When an exploding ARM resets four or five percentage points, the monthly mortgage payment goes up an average of 29 to 50 percent [source: U.S. Congress Joint Economic Committee]. So if you were paying $2,000 a month, now you're paying $3,000. Most people can't afford that much of a leap. This is why there was a 90 percent increase in foreclosures on subprime loans from 2006 to 2007 [source: Center for Responsible Lending].

Foreclosures are bad news for everyone involved. A foreclosure can cost up to $80,000 split between homeowners, lenders, neighborhoods and local governments [source: U.S. Congress Joint Economic Committee]. And when several houses in a neighborhood are foreclosed, the prices of the surrounding homes begin to drop quickly. The Center for Responsible Lending estimates that 44.5 million American homes will lose an average of $5,000 in value in the next few years due to nearby foreclosures [source: Center for Responsible Lending]. That's $233 billion of lost home equity. And that's why it's called a housing "crisis."

­So how can you avoid getting swindled by predatory lenders? What are proven techniques for securing a safe loan? Read on to find out.

Knowledge is the best weapon against predatory lending. To avoid getting trapped with a lousy loan, the first step is to educate yourself on mortgage terminology and basic concepts:

You should also know your rights as a borrower. Never let lenders convince you that they're the only one who will give you such a great "deal" on a mortgage. You're the customer and it's your right to shop around. Visit at least three different lenders to hear their offers. Never let anyone convince you to lie on a mortgage contract. If you embellish your earnings, for example, then you might end up with a monthly mortgage payment that you simply can't afford.

Get everything in writing. As the old saying goes, "An oral contract isn't worth the paper it's written on." You have to pay the interest rates and adhere to the terms that are written in your loan contract. Everything else is just talk. Never sign a loan contract that has blank spaces in it that the lender says he or she'll "fill in later." If something doesn't apply to you, draw a line through it in the contract.

Consult a nonprofit credit counselor. We're not talking about debt consolidation services -- many of those are scams. We're talking about nonprofit organizations in most major cities that assist people with debt and credit questions. If you have any doubts about a mortgage agreement, take the contract to the credit counselors to catch any red flags.

And finally, never agree to a loan that you can't afford right now or won't be able to afford in a couple of years. If you choose an adjustable rate mortgage, look at what the payments will be like in two or three years. If you know they're too high, then change the terms of the loan. Don't let anyone tell you that your financial situation could change significantly for the better in the course of two years. Or that you could take out more ­debt to make your mortgage payments. That could start a downward credit spiral that ultimately leads to bankruptcy.

We hope this has been a helpful introduction to predatory lending. For even more information on home buying and money management, take a look at the links on the next page.

We're in the process of buying our first house. I consider myself a pretty sharp guy, but financial matters have never been my strong suit and fine print might as well be written in invisible ink. That makes me a potential target for predatory lending. If I hadn't researched predatory lending tactics for this article, I may have believed a lender who tells me not to worry about the adjustable rate on my mortgage, because my income will probably go up in the next couple of years. Or I might not even think that it's a big deal for an interest rate to jump four percentage points in a single day. Unfortunately, millions of Americans were swindled by predatory lenders during the subprime lending craze. Lucky for people like me, there are new laws and regulations in place that ensure greater transparency and full disclosure during every step of the home buying process.

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