The majority of lending professionals out there play by the rules and care about their customers.
Unfortunately, there are some bad actors who take advantage of borrowers. Getting stuck with a predatory loan can cost a borrower a ton of money or even the ownership of their home.
As an agent, you should keep an eye out for predatory lending red flags. You can't make your clients' lending decisions for them, but you can bring their attention to potential issues with their loan.
What Is Predatory Lending?
Predatory lending involves unfair, deceptive, or fraudulent practices during the loan origination process. While there are no legal definitions in the United States for predatory lending, an audit report on predatory lending from the office of the inspector general of the FDIC broadly defines predatory lending as, "imposing unfair and abusive loan terms on borrowers.”
Common Predatory Lending Practices
Let’s talk about a few ways that unscrupulous lenders operate. Here are some predatory lending practices you may run into.
Equity stripping is when a lender makes a loan on a borrower's home equity that they may not be able to pay back. If not, they repossess the home.
Bait and Switch
A bait and switch tactic is when a lender advertises a good rate or loan product but then provides a different, less-good one to a borrower for no stated reason. The unfavorable terms might be hidden, like large fees, a too-high variable rate, or other nasty surprises.
Packing involves charging the borrower for services or fees they don't actually need. A common one is unnecessary mortgage insurance.
Hidden Balloon Payments
This technique involves offering a low rate, then revealing at closing that the lender is actually offering a balloon loan that will have to be refinanced or paid off in a few years.
Subprime Lending and Predatory Lending
When people hear “predatory lending,” they often think of subprime loans. Predatory or otherwise bad subprime loans were one of the drivers of the 2008 financial crisis. And while there are bad subprime products, subprime loans themselves are not inherently predatory.
What Are Subprime Loans?
Subprime mortgages are a type of mortgage that is normally made to borrowers with lower credit ratings. The lender offers a mortgage with a higher interest rate because the lender views the borrower as having a larger-than-average risk of defaulting on the loan.
Subprime Loans Aren’t Inherently Predatory
Subprime lending can go wrong (and it certainly has in the past). But that doesn’t mean that subprime mortgages are always bad or predatory. They just have terms that correlate to their increased risk levels for the lender.
Some borrowers may not be able to qualify for any loans other than subprime loans. As long as they fully understand and accept the loan terms, it’s not a predatory loan.
Subprime Loans to Watch Out for
Okay, so what kinds of subprime loans should you be careful of, then? Lenders have become creative in the way they structure subprime mortgages in ways that may be unfavorable to the borrower. If you see any of these features in a loan your client is considering, urge them to shop around some more.
Some subprime loans, particularly ones with adjustable interest rates (ARMs), will have a prepayment penalty. That means that if the borrower wants to pay back the balance of the loan before the end of the 15- or 30-year term, they have to pay an additional fee.
That’s a problem in a lot of ways. It means the borrower will pay extra when they sell their home or refinance their loan. Say interest rates are going up and someone with an ARM wants to refinance into a fixed-rate loan. They will pay a fee to do that. Borrowers should avoid loans with prepayment penalties!
No Interest Rate Cap
This one also applies to ARMs. Most adjustable-rate mortgages have a rate cap, meaning that no matter what the market does, the loan’s interest rate can’t go above a certain amount. Some less-than-great subprime ARMs lack a rate cap, so the borrower can find their monthly payment going up and up and up until they can’t afford it anymore.
Red Flags for Predatory Lending
Some of these issues we’re talking about are kind of technical. You’re not a mortgage broker, you’re an agent, and you may not be getting into the nitty-gritty of your client’s loan package. That’s okay! Instead, keep an eye out for these red flags. Any of these behaviors in a lender or loan originator should serve as a warning that your client should proceed with caution.
Remember, even borrowers looking for a subprime loan should shop around, compare rates and terms, and get the best possible loan.