Predatory lending consists of a number of practices that exploit consumers and can result in the loss of homes and life savings. Predatory lending includes both technically legal, but high cost, loans and outright fraud through deceptive lending practices. A common element of all predatory loans is exploiting a consumer's ability to repay. Borrowers are often lent amounts far in excess of what their incomes can support. Another characteristic is interest rates and fees that are well in excess of what is needed by a lender to compensate for risk and earn a reasonable profit.
A key characteristic of predatory loans is their prey, or target consumer. Predatory lenders aggressively market to vulnerable groups. They often capitalize on the desperation of homeowners who need money immediately and can't wait, or can't qualify, for a traditional bank loan. Elderly and minority consumers are frequent targets of predatory lenders.
A "red flag" of predatory loans is a high debt service-to-income ratio. In other words, borrowers are allowed--even encouraged--to borrow more than they can afford. Predatory lenders don't care if borrowers can't keep up with the monthly payments. As soon as borrowers can't pay what is owed, the lender will encourage them to refinance or will simply foreclose, taking away a person's house and the home equity they have spent years building.
Predatory lenders try to hook borrowers with the promise of low monthly payments. Many use telephone and door-to-door solicitations in "targeted" neighborhoods, as well as direct mail, fliers, and the Internet to lure borrowers. Of course, the reason predatory loan payments are so low is that the term of the loan is extended, sometimes for decades. Payments for loans stretched out over 20 years will always be less expensive, on a monthly basis, than loans that take five years to repay. The total cost, of course, is another matter.
A third "red flag" of predatory loans is a high loan-to-value (LTV) ratio. A loan-to-value ratio is calculated by dividing the amount of a mortgage loan by the value of the home that is being used as security for the loan. For example, a $75,000 loan on a $100,000 home would have an LTV ratio of .75 (75%). Loan-to-value ratios on typical mortgage loans are typically 80% of the appraised value of a house, or less. Predatory lenders often lend 100% and sometimes 100% to 125%, of a home's appraised value.
Not all predatory loans involve houses and home equity. In fact, some of the worst offenders, in terms of predatory practices, are not mortgage lenders at all but, rather, non-mortgage consumer lenders. Some examples are paycheck loans, pawnshop loans, car title loans, rent-to-own plans, and advanced fee loan scams.
Becoming an informed consumer is the best protection against predatory lending practices. Unfortunately, many predatory lenders harm consumers before government regulators can close them down. By the time they are caught and prosecuted, damage has already been done.
The best way to avoid predatory lenders is to understand how they operate. As in many life situations, "knowledge is power." Walk away from any lender that encourages you to borrow more than you need, requires life insurance, has loans with balloon payments coming due in under 10 years, charges excessively high costs, doesn't answer all of your questions, and provides a blank contract with spaces "to be filled in later." Never sign a loan contract you don't understand and always check that terms that were told to you orally are the same in the loan contract.