Guadalupe Nuñez has never owned her own home, but the man on the phone says now is the time to buy. It's the summer of 2005, and this is the third time the man has called this week. Nuñez, a widow who came to the United States in the 1980s, has a hard time understanding exactly what the man is saying. Something about a 7 percent adjustable interest rate, $30,000 cash back and a monthly mortgage payment of less than $1,500.
Nuñez gets excited. On the local news, they keep saying how the housing market is going up and up and up. If she can scrape together enough to buy this house, she thinks, then she can sell it in five years and retire comfortably.
The man comes over with the paperwork. He seems to be in a rush, telling Nuñez to leave some parts blank. He brings a real estate agent with him, who tells her that if she signs today, she won't be charged special closing fees that will go up to $10,000 in a week.
Nuñez is a little confused, but she knows she wants this house, so she signs everything they put in front of her, never clarifying that her 7 percent APR will leap to 12 percent after the second year. Or that the mortgage lender is actually selling her two loans that will total more than $3,000 a month. When the deal is over, Nuñez is stuck with a mortgage that she can never repay and a house that will never really be hers. The bank forecloses two years later.
Nuñez is a fictitious example. But millions of people just like her are victims of predatory lending. Predatory mortgage lenders target first-time homebuyers with bad credit ratings -- often minorities and the elderly -- and convince them to buy homes with risky adjustable-rate mortgages, or other types of subprime mortgages.
The best defense against predatory lending is knowledge. Read on to learn the most common tactics used by predatory lenders and how to avoid getting trapped in a financial nightmare.
What is Predatory Lending?
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.
Effects of Predatory Lending
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.
How to Avoid Predatory Loans
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 need to know the basic differences between fixed rate and adjustable rate mortgages.
- You need to understand how principal works and the risks and benefits of interest-only loans.
- You should be familiar with potentially dangerous requirements like prepayment penalties and mandatory arbitration (where a borrower is denied the right to take a lender to court over unfair loans).
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.
How Predatory Lending Works: Author’s Note
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.
- "A Snapshot of the Subprime Market." Center for Responsible Lending. Nov. 27, 2007. http://www.responsiblelending.org/issues/mortgage/quick-references/ a-snapshot-of-the-subprime.html
- "AGs, Ameriquest Reach $325 Million Predatory Lending Settlement." Phoenix Business Journal. Jan. 23, 2006. http://www.bizjournals.com/phoenix/stories/2006/01/23/daily10.html
- Bair, Sheila C. "Fix Rates to Save Loans." The New York Times. Oct. 19, 2007. http://www.nytimes.com/2007/10/19/opinion/19bair.html
- "Common Abuses: Seven Signs of Predatory Lending." Center for Responsible Lending. http://www.responsiblelending.org/issues/mortgage/sevensigns.html
- "Comprehensive mortgage reform and anti-predatory lending legislation introduced in the House." House Committee on Financial Services. Oct. 22, 2007. http://www.house.gov/apps/list/press/financialsvcs_dem/ press102207.shtml
- "Don't Be a Victim of Loan Fraud." U.S. Department of Housing and Urban Development. http://www.hud.gov/offices/hsg/sfh/buying/loanfraud.cfm
- "New Center for Responsible Lending Research Finds Subprime Foreclosures will Drain Billions from Surrounding Home Values." Center for Responsible Lending. Nov. 13, 2007. http://www.responsiblelending.org/press/releases/subprime-foreclosure- spillover.html
- Said, Carolyn. "Legislating a way out of the housing crisis." San Francisco Chronicle. Apr. 27, 2008. http://www.sfgate.com/cgi-bin/article.cgi? f=/c/a/2008/04/27/BU7Q10AQJ3.DTL&tsp=1
- "Sheltering Neighborhoods from the Subprime Foreclosure Storm." U.S. Congress Joint Economic Committee. Apr. 11, 2007. http://jec.senate.gov/index.cfm?FuseAction=Reports.Reports& ContentRecord_id=c780213f-7e9c-9af9-761d-fd7e597b5cfe&Region_id =&Issue_id
- "Unfair and Unsafe: How Countrywide's irresponsible practice have harmed borrowers and shareholders." Center for Responsible Lending. Feb. 7, 2008. http://www.responsiblelending.org/pdfs/unfair-and-unsafe-countrywide- white-paper.pdf
Predatory Lending: Cheat Sheet
Stuff you need to know:
- Predatory lending is any misleading or dishonest lending practice that targets uninformed homebuyers or borrowers with poor credit.
- Some predatory lenders commit loan fraud -- consciously misleading homebuyers about the price of their loan -- while others tack on hidden fees and insurance policies that pad the loan with unnecessary charges.
- Adjustable rate mortgages (ARMs) are one of the favorite tools of predatory lenders. Uninformed borrowers think they are signing up for a 7 percent interest rate, but the initial "teaser" rate can jump to 12 percent or higher after only a few years.
- Before you sign any type of mortgage loan, educate yourself on the basics of fixed vs. adjustable rates. Consult a non-profit credit counselor (not a debt consolidation service) and have them review your finances to make sure you can afford a new home with a traditional fixed rate mortgage.