Access to Credit: Predatory Lending and Payday Loans

There are moments in life when an unexpected financial hardship strikes at exactly the worst time. Maybe your boss cuts your hours at work or your car needs expensive repairs. Suddenly your budget is blown, but the rent is still due and you’re already at or near your limit on your credit cards. In times like these, if you don’t have any savings to pull from, what are your options?

Your options could be limited to payday lenders, which offer fast cash, but usually at a steep cost. A loan from a payday lender may help you make rent this month, but the sky-high interest rate they’ll charge will add to your debt and could make it even more difficult to pay all your expenses next month. 

For some consumers, these quick loans may seem like the only option. But too often, payday loans and other fast-cash arrangements cross the line into predatory lending. People who have been targeted by payday loans or other predatory lending might ultimately end up needing debt relief.

Predatory lending describes the various tactics that some lenders use to exploit mainly low-income borrowers with products that don't benefit them in the long run. Predatory lending could trap you in a cycle of debt and leave you worse off than you were before.

Predatory lending practices take advantage of people who are in desperate financial shape. They also tend to cause their biggest harm to minority communities that have already endured generations of financial discrimination. For decades, redlining and other forms of mortgage discrimination created a situation where many minority neighborhoods have a lack of banking services, factors that continue to contribute to the racial wealth gap in the United States today.

While generational inequity won’t be solved overnight, there are ways to avoid exploitative and predatory financial practices. Let’s take a closer look at predatory lending, why payday loans are bad for your financial health, how predatory lenders especially tend to target communities of color, and what you can do to help protect yourself and your loved ones from these destructive financial products and services.

What is predatory lending?

Just as it sounds, the term predatory lending refers to  lenders “preying” upon people who are financially vulnerable. This includes those who have poor credit, limited savings, or insufficient financial options. Some people might have decent credit and savings, but still fall into the trap of predatory lending if they lack financial knowledge to understand the often-complex terms of the loan. 

It’s important to remember that people who become prey to predatory lenders are not unsophisticated or foolish, and they do not deserve to be overcharged or cheated out of their hard-earned money. Many borrowers who sign up for predatory lending agreements know exactly what they’re getting into, but believe they have no other options. Other people are simply misled or defrauded by lenders.

Predatory lending practices often take place in underbanked minority neighborhoods, but anyone can be vulnerable to predatory lending. And although predatory lending doesn’t only happen to people of racial minority groups, it can be a form of racial credit discrimination—because predatory lending tends to be more likely to occur among minority customers. 

Sometimes minority customers who have good credit and could qualify for better loan options, regardless of where they live, are routinely steered toward exploitative (or more expensive) loans just as a form of racially discriminatory treatment by lenders.

There's no overarching legal definition for predatory lending, and laws differ by state. But the Federal Deposit Insurance Corporation (FDIC) official policy says that a few signs of predatory lending might include: 

• Lack of fair exchange of value 

• Loan pricing that exceeds the borrower’s risk to the lender or that exceeds customary standards

• Making loans that are unaffordable and that are based on the assets of the borrower, instead of the borrower’s ability to repay the loan 

• Encouraging a borrower to refinance a loan repeatedly so the lender can charge extra fees

• Using fraud or deception to conceal the true nature of the loan, or related products, from an unsuspecting or unsophisticated borrower 

The word “predatory” can describe legal and illegal lending activities (which vary according to state laws) that are often considered exploitative in nature. For instance, many payday lenders, check-cashing companies, and even some traditional banks sometimes employ tactics that, while legal, are not beneficial to the consumer. Common types of predatory lending might include the following.

Subprime mortgage loans

Many home buyers who can’t qualify for a prime loan can qualify for a subprime (or “nonprime”) mortgage, even with credit scores as low as 500 and with very little or no down payment. Not all subprime mortgages are predatory. Some people have poor credit or no credit history, and need a little extra help to qualify for a mortgage. Making it possible for people with lower credit scores to afford homes is not necessarily a predatory way of doing business. 

But subprime loans can be riskier than traditional mortgages. Subprime loans tend to charge higher interest rates, and subprime mortgages might also be more likely to be adjustable rate mortgages (ARMs) that can lead to higher monthly payments if interest rates go up. 

People with less than fair credit might be so excited about being offered a path to homeownership that they overlook (or don’t understand) the total cost and risk of a subprime mortgage.  Choosing a subprime mortgage might cause some borrowers to buy more home than they can actually afford, which puts them at risk of default, foreclosure, or other financial stress. 

Even though subprime loans can be risky, they are legal—but lenders have to be fair in how they advertise and sell these loans. Lenders are required to clearly disclose the loan terms, and must not discriminate on the basis of race or other characteristics. 

Subprime lenders are also required to be careful not to issue loans to borrowers who aren’t likely to repay. Buying a home, even with a subprime mortgage, is supposed to help set you up for financial stability and long-term success—not leave you in worse financial shape. 

Loans sold by focusing solely on monthly payments

How do you know if a loan is a good deal for you or not? Monthly loan payment amounts are just one piece of the bigger picture. Predatory lenders often gloss over or ignore the other terms of a loan and instead focus solely on touting low monthly payments. But just because a loan has low monthly payments doesn’t mean it’s the best choice. 

Some loans have low payments because the loan term drags on for many years, with a higher interest rate. Don’t get dazzled by low monthly payments. Instead, make sure you understand the total cost of the loan, how long you’ll be paying off the debt, and how much total interest you will pay along the way. 

Balloon payment loans

Instead of making a large down payment when signing for a loan, certain lenders may suggest a “balloon” loan requiring the borrower to make one big payment at the end of the term. For example, with an auto loan, the balloon payment might not be due for five or seven years. 

Not every balloon payment loan is “predatory,” but sometimes this method of lending is used by unscrupulous lenders. Balloon payments can be risky, because if you fail to make that last big payment, you might lose the car (or home) that your loan was used to purchase. 

Borrowers offered a balloon payment loan might be promised a lower monthly payment and a lower interest rate, but not be clearly told about the risk of having to make that balloon payment at the end of the term. Predatory lenders who fail to fully explain the risks of balloon loans are hoping to lure borrowers with their balloon loans’ low initial cost. Some people can be a good fit for a balloon loan. If you believe (or hope) that your income will be higher and your financial situation will be better in a few years, and you’ll be comfortably able to write a check for that final payment, a balloon loan can be a good choice. But for many people, a balloon loan is not the right choice. The risk of failing to make that big final payment—and losing your car or house—is not worth saving money in the short run. 

Negative amortization loans

Borrowing money costs money, because you pay interest to the lender. With most loan payments, every payment contains some amount of principal (the original balance of the loan that you borrowed) and interest (the money that the lender charges to you). Many loans like mortgages and auto loans “amortize” over time—the amount of interest that you pay each month gradually goes down, even while your monthly payment stays the same. 

But some loans don’t amortize. This type of loan is called a “negative amortization loan,” because it gives you the option to make low minimum payments that are less than the cost of the interest. But if you never pay down the interest or principal, you’ll never pay off the loan and the balance will increase every month. 

Loans that result in a negative amortization, at least temporarily, aren’t necessarily illegal, or even considered predatory. For instance, your student loans may negatively amortize while you’re in school and not making monthly payments. 

But if a lender is not allowing you to see or understand how much you need to pay in order to properly amortize the loan, this could be predatory. And in general, negative amortization loans should be avoided unless you’re in a financial emergency and cannot afford to make debt payments. 

Packing

“Packing” loans is a predatory lending practice that happens when lenders add extra fees, charges, and penalties, usually found in the fine print. Predatory lenders try not to discuss these fees or extra loan terms with the borrower, because the lender hopes the borrower will sign the loan papers without understanding the impact of these additional fees. One common way for unscrupulous lenders to pack a loan is to add a fee for loan insurance, which in many cases is unnecessary.

You May Like These

Access to Credit: Auto Loans and Mobility

Credit Card Debt

What Are Debt Strategies?

Why payday loans are bad for your financial health

Payday loans are one of the most common types of predatory loans. Payday lenders use many of the unscrupulous, unfair, or unnecessarily expensive methods shown above. Payday loans are legal in 37 states, but various states have different laws and limits on how much people can borrow and how much these lenders can charge. 

Here’s why payday loans are a bad deal for many people: they charge high fees. For example, a typical payday loan might charge fees of $10 to $30 for every $100 borrowed. If you’re unable to pay off your loan on the assigned date, you may be offered a “rollover” for an additional fee. This can lead people into a vicious cycle of being trapped by debt: 75% of fees collected by payday lenders come from borrowers who take out 10 or more loans per year. Payday lenders may also pack the loan with additional fees and, if the loan is put onto a payment card, there may also be transaction or cash-advance fees. 

How to protect yourself from predatory lending

People of all races, incomes, and credit scores deserve to get fair treatment and a good deal from banks, lenders and financial services providers. Even if you have the lowest credit score, you don’t deserve to be tricked or scammed by payday loans or predatory lenders. 

Knowledge is power. Here are a few tips to protect yourself and your loved ones from predatory lending. 

If you feel pressured, walk away

Whether you’re applying for a mortgage or a smaller payday loan, you should not feel pressured to accept the terms. High-pressure sales tactics are a red flag that the loan may not be right for you.

Do not sign blank documents

Predatory lenders may try to convince you that they need your signature for terms that are yet to be finalized, but you should never sign a blank document. Ethical lenders will clearly show you the fine print of any contract or loan document, and will allow you time to read it before you sign.

Do not make false statements

Some predatory lenders may offer loans they know you can’t repay, and as part of this predatory process, the lender might encourage you to make inaccurate statements about your income or assets. Don’t do it! 

Making false statements on a loan application is a crime. And if you get involved with making false statements to “help” a lender give you a loan that you’re not qualified to repay, you could lose your rights to sue the predatory lender in the future. 

Mind your credit score

If the lender suggests that your credit score doesn’t matter or that they don’t care about your credit score, that should raise a red flag. Even if you have less than perfect credit, your credit score is always important. Everyone at all levels of creditworthiness should take steps to build and protect your credit score.

Look into online lenders

Since online banks and other lenders don’t have brick-and-mortar locations, they’re often cheaper and easier to use than traditional banks and can offer better terms than payday loans. Some online lenders can offer you an online checking account and other useful financial services, along with small-dollar loans or lines of credit. Instead of using payday loans, signing up for an online banking app could be a better choice. 

Remember legal protections for military service members

If you’re a military service member, you have some extra rights and protections when borrowing money. The Military Lending Act prohibits loan rollovers and interest rates greater than 36 percent, and provides some additional protections for military service members and their families.

Whether it’s a payday loan, credit card, or a purely non-predatory auto loan or home mortgage, it’s important to make sure you understand what you’re agreeing to before you borrow money: 

• Read the fine print. 

• Understand the interest rate (APR). 

• Ask about the total cost of the loan. 

• Make sure there’s no prepayment penalty if you want to pay off your debt early. 

• Be realistic about how your new loan payment will fit into your monthly budget. 

Spot the signs of predatory lending and borrow with dignity

Freedom Debt Relief wants every borrower to have a better experience when dealing with lenders and creditors. Financial discrimination and unfair practices do happen sometimes, but we believe that if people can be better educated and empowered, they’ll be more likely to know their options and hopefully avoid predatory lenders and debt traps. Knowing the risks of loans, and watching out for red flags of predatory lenders, can help people make better financial plans for their future.