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Predatory Lending

In: Business and Management

Submitted By aphuppman
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Predatory Lending: The Sub-Prime Mortgage and Payday Industry
Andrew Huppman
Bloomsburg University

Author Note
This paper was prepared for Markets and Institutions, Finance 323, taught by Professor Geyfman
Abstract
Predatory lenders are growing at an alarming rate; in this paper I will provide an examination of predatory lending patterns and the effects on the markets and consumers. Predatory lending is defined as the practice in which a loan is made to a borrower in the hope or expectation that the borrower will default. (Predatory, N.D.) The market for short-term loans have only been around for the past twenty years, however, has expanded at such a rate that there are now more short-term lenders in America than there are Starbucks and McDonald’s. (Center, 2011) Borrowers of this financial service lack necessary information to choose financial products, do not see themselves as having any other financial options, and are enticed by the ease of approval. Predatory lenders are not concerned with the risk. A subprime loan can be approved with as little as proof of a pay stub and requires no credit checks. Most loans are short term which tricks consumers into believing their costs will be minimal. In reality, these short-term rates force borrowers to pay annual percentage rates (APR) exponentially larger than anticipated. In today’s market there is a wide variety of predatory lending practices. The main culprits are predatory mortgage lending practices and payday loans.
Predatory Mortgage Lending
Predatory mortgage lending was first seen in the 1990’s after deregulation of the banking industry in the 1980’s and the creation of sub-prime loans. This allowed banks to sell loans with interest rates above the state’s interest limit. (Reed, 2014) Sub-prime loans were offered to borrowers with low income and poor credit as a chance to enter the real estate market. Before sub-prime mortgage lending, borrowers would often get turned down from companies and banks for mortgages because they simply did not earn enough income to afford the house in question. A sub-prime loan allowed borrowers to have the ability to buy the house of their dreams.
The danger in these loans is it tricks consumers into believing they can afford a house that is far out of their price range. The loans are made to be attractive and easy enough for anyone to be preapproved. Sub-prime mortgages are so attractive that in Atlanta, Georgia, the amount of sub-prime loans increased 500% from 1993 to 1998. (History, N.D.) The graph in the appendix shows across the nation the total monthly balance of sub-prime loans grew from $111.6 billion in 2000 to $840.8 billion at its peak in 2007 before the recession. (Fun, N.D.)
They accomplish this by offering what lenders call “affordability products.” (Reed, 2014) For example, a negative amortization loan allows a borrower to only pay the interest due on the loan each month then upon maturity, the full principal is due at once. These tactics use teaser costs that are low in the beginning but towards the end, are much higher than originally thought possible. Another tactic used by lenders is called “fee packing.” (Negative, 2011) This refers to hidden and often unnecessary fees tacked onto loans to make more profit for the lender.
A lender is able to hold onto mortgages to collect the interest payments and fees. They will continue to do this or they can drop all of their risk and bundle loans to sell to third parties. Most will decide to bundle and sell the loans because they know how risky these loans are and expect the borrowers to default upon the payments at some point. When the lender has sold your loan, the lender has no risk and simply accepts fees from the third party for collecting the borrowers payments and transferring the funds to the third party. This allows the lenders the freedom to create as many mortgages as possible while not having to consider the borrower’s credit risk. (Diaz, 2008) As I pointed out earlier in the graph in the appendix, the peak of the sub-prime mortgage industry was right before the recession in 2007. This is because when borrowers began defaulting on their payments, payments stopped being made which caused third parties to not receive their payments and the sub-prime lenders then were not receiving their fees. In order for borrowers to pay off their mortgages their houses would forced to be foreclosed and sold. Foreclosure is relevant even with prime mortgages, however, the rate at which properties bought with sub-prime mortgages were being foreclosed made the values of the properties drastically drop and made it near impossible for the houses to be sold. At the height of the recession in late 2008, the total monthly balance of foreclosures due to sub-prime mortgages hit $91.6 billion. This dwarfs the amount in 2000 when foreclosures were only at $4.7 billion. (Fun, N.D.)
How to protect yourself
In this paper so far I have gone through the history and practices of predatory mortgage lending, however, just like there are an abundance of predatory lenders there are also many lenders out there who will treat you fairly. It is still possible to qualify for a fair loan or mortgage; you just need to be a savvy shopper. In this next section I will provide you with advice for avoiding a predatory lender and finding an appropriate lender. Before beginning the process of visiting lenders, talk to people in your life like family, friends, or coworkers who have had good experiences with their lenders. A quality referral from a trustable source could save you some time when searching and prevent you from being sold on some wild spam mail or advertisement offer. Steer clear of lenders who promise your loan will be approved no matter how bad your credit score is. Next, it would be wise to collect offers from multiple lenders; you should have at least two to three offers before you begin to compare loans.
When comparing offers be sure to look at the costs, interest rates, and fees. When you talk to lenders, be sure to ask for a list of the fees that are involved with the loan. Quality lenders should be able to clearly explain to you all costs included and provide you with a good faith estimate. It is crucial to carefully read through all the paperwork; predatory lenders will charge inflated fees that are much higher than normal and will attempt to hide them in the fine text. When reading the contracts, be aware of hidden clauses that force mandatory arbitration. This clause makes it illegal for victims of predatory lending to seek legal action for fraud or misrepresentation and forces the victim to only have a choice of arbitration, which immediately gives the lender the advantage.
Do not allow yourself to be rushed into signing anything. A predatory lender will attempt to encourage you to sign so you may overlook fees or restrictions. Two red flags of predatory loans are large prepayment penalties and blank spaces in the contracts. Up to 80% of sub-prime mortgages have unusually high prepayment penalties. This charges the borrower a hefty fee for attempting to pay off their loan early. If you find any blank spaces in the documents, you should immediately refuse the loan until they are removed. This is an easy and deceitful way lenders will add fees or clauses after borrowers have signed. Another way around this is to put “N/A” in the blank spaces. This can prevent the lender from being able to fill in the blanks later and prevent you from being held liable for any adjustments made after you sign.
The last step is if you are looking for a mortgage, you should hire an independent appraiser. Reputable lenders want to set you up with a loan that you will be able to repay in the future. Predatory lenders on the other hand, make their profit from your inability to pay your debt. A sub-prime mortgage lender will often times influence appraisers to value the price of homes above what they are actually worth so they are able to sell you a larger loan. This over valuing will cause your repayment to be much larger than originally expected. An over valuation will prevent you from being able to refinance your mortgage and make it nearly impossible for a borrower to sell the house in the near future without taking a significant loss.
Payday Loans
Payday loans are a rather small amount of money ranging from $100 to $1,000 that is lent to borrowers with exceptionally high interest rates. These loans are meant to fill monetary gaps in between a borrowers pay period and are in theory to be paid back when the borrower receives their next paycheck. (Center, N.D.) 69% of first time borrowers of payday loans use it to cover a reoccurring living expense such as rent or utility bills. (Campaign, 2011) Borrowers who do take out a payday loan have 98% likelihood to have to be reoccurring customers, often in order to pay off the original loan. Payday loan companies, such as Ace Cash Express, are aware of this trend and actually train their employees to sell customers, who can’t afford their original loan payments, another payday loan. This puts the customer into a never-ending pit of debt that they are unable to escape, a tactic known as a “debt trap” (CFPB, N.D.) and is the reason why the average customer will have to take out nine payday loans every year.
Payday loans are offered by stores, these stores are considered “non-bank financial entities.” This minute difference allows payday stores to not be regulated by banking agencies and their borrowers are not protected the same as bank customers. Since banking agencies does not regulate the stores, lenders in some states are able to charge any interest rate they want. Three commonly known high interest rates are credit cards typically at 16%, installment car loans at 18%, and sub-prime mortgage loans at 10%. The average annual percentage rate on a payday loan is 443%.(Bertrand, 2011)
Consumers often feel forced into using payday loans because they feel as though they have no other option. Most users are not able to open credit cards because of their poor credit history. Lenders trick consumers into borrowing money by advertising their fees in terms of two weeks, even though lenders rarely are able to pay back the amount in two weeks. Advertisements will usually quote prices as “$15 for every $100” for a loan with an interest rate of 15%. What they don’t advertise is an interest rate of 15% on a two-week loan would end up equaling an annual percentage rate of 390%. In 2000, the Federal Reserve board made it a legal requirement, under the Truth In Lending Act, for payday lenders to disclose annual percentage rates on their loans. (Center, 2009) It is important for borrowers to understand the annual percentage rate of the loans they take out even if they do not plan on having the loan for a long time because it allows them to compare financial options. When interest of payday loans are shown next to those of credit cards, typically 18%, it becomes clear to borrowers how unacceptable these rates are.
Parties in defense of payday lenders argue that their product provides relief to their customers. Lenders feel good about their business because they can help those in between paychecks afford basic necessities such as rent and groceries. Even those who are opposed to payday lending, admit that the service is a necessary evil because it does keep individuals from having their utilities being shut off, being evicted, or going hungry. In situations like these, the borrowers do not need advice on how to improve their credit score or more efficient ways of handling their finances, they simply need cash at that moment. Lenders also testify that their prices are competitive with other options, such as banks that charge a $4 overdraft fee for every day an account is overdrawn. Also, even with the outrageous annual percentage rates and fees, payday stores are still only making average returns for a business. Average profits for a payday store only come out to 10% after accounting for maintenance costs and writing off bad loans. (Epstein, 2010)
Payday lending has been a heated topic recently in legal debates. So far, the federal government has made it illegal to charge military service members more than 36% for a loan. This now has average citizens asking where their protection is. Many states are hearing the complaints and are becoming aware of the harmful effects the payday loan industry has on their citizens. An estimated 12 million Americans every year are caught in an endless loop of paying over 400% on payday loans. (Center, N.D.) So far, 17 states and the District of Columbia now prohibit interest rates above 36%. Washington State was able to set an amazing interest rate cap of 15% and in just a year, since the law was enacted, the state has been able to save consumers more than $122 million in fees. There are still 33 states to pass legislation on payday lenders or interest caps but with the creation of Dodd-Frank that number may be dwindling soon. The Dodd-Frank Reform has given the Consumer Financial Protection Bureau the ability to go after deceptive, unfair, and abusive acts in the financial markets. So far the agency has been able to root out a large payday lender that they found guilty of all three. Ace Cash Express, the company responsible for the debt trap diagram discussed earlier, has agreed to pay $10 million to resolve concerns from the Consumer Financial Protection Bureau. The company was claimed to have participated in illegal debt collection tactics consisting of harassment and false threats. (CFPB, 2014)
No matter what laws are enacted, predatory lenders will always find a way to make a quick buck off of unsuspecting borrowers. The best offense to keep your finances safe is a solid defense. Always read the fine print in loan contracts and remember that annual percentage rates are important even for two-week loans. Also, when considering a loan, only borrow what is absolutely needed and pay it off as soon as possible. Limiting the amount of your loans and the duration will end up saving a lot of money in the future.

(Fun, N.D.)
(CFPB, N.D.)
Sources
Bertrand, M. (2011). Information Disclosure, Cognitive Biases, and Payday
Borrowing. The Journal of Finance, LXVI(6). Retrieved November 2, 2014.
Campaigns | Predatory Lending. (2012, January 1). Retrieved October 1, 2014, from http://www.illinoispeoplesaction.org/predatory-lending.html Center for Responsible Lending. (n.d.). Retrieved November 2, 2014, from http://www.responsiblelending.org/payday-lending/ Center for Responsible Lending. (2009, June 23). Retrieved November 3, 2014, from http://www.responsiblelending.org/payday-lending/research-analysis/apr-matters-on-payday-loans.html CFPB: ACE Cash Express Must Pay $10M For Pushing Borrowers Into Payday Loan Cycle Of Debt. (n.d.). Retrieved November 2, 2014, from http://consumerist.com/2014/07/10/cfpb-ace-cash-express-must-pay-10m-for-pushing-borrowers-into-payday-loan-cycle-of-debt/ CFPB alleges UDAAP trifecta in payday lending enforcement action. (2014, July 1).
Retrieved October 4, 2014, from http://www.doddfrankupdate.com/DFU/ArticlesDFU/CFPB-alleges-UDAAP-trifecta-in-payday-lending-enfo-61402.aspx
Diaz, F. (2008, March 18). Financial Institutions’ Responsibility in the Subprime
Mortgage Crisis. Retrieved October 18, 2014, from http://www.ethicalquote.com/docs/SubprimeMortgageCrisis.pdf
Diaz, F. (2008, March 18). Financial Institutions’ Responsibility in the Subprime
Mortgage Crisis. Retrieved October 18, 2014, from http://www.ethicalquote.com/docs/SubprimeMortgageCrisis.pdf
Epstein, J. (2010, November 3). Reason.tv: In Defense of Payday Lending. Retrieved
October 10, 2014, from http://reason.com/blog/2010/11/10/reasontv-in-defense-of-payday
Fun With Predatory Lending | The Big Picture. (n.d.). Retrieved October 8, 2014, from http://www.ritholtz.com/blog/2012/06/fun-with-predatory-lending/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed: TheBigPicture (The Big Picture)
History of Preditory Lending. (n.d.). Retrieved October 8, 2014, from http://mortgage-home-loan-bank-fraud.com/articles/history_of_predatory_lending. Negative Amortization and Predatory Lending. (2011, January 1). Retrieved October
5, 2014, from http://www.mortgage-trader.com/mortgage-amortization/predatory-lending.html
Campaigns | Predatory Lending. (n.d.). Retrieved December 4, 2014, from http://www.illinoispeoplesaction.org/predatory-lending.html Reed, M., & Konczal, E. (2014). Point: The Greed of Big Businesses Caused the
Subprime Mortgage Crisis. Points Of View: Sub-Prime Mortgage Crisis, 2.

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Words: 308 - Pages: 2

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Countrywide Financial

...Angelo Mozilo, founder and Chairman of Countrywide Financial Corporation, the driving force behind the company’s zeal to become the largest real estate mortgage originator in the United States. The same zeal leads to the company’s collapse and led to an extraordinary collapse of the US housing market. Mozilo and partner, David Loeb, founded Countrywide in 1969 in New York with the strategic intent of creating a nationwide mortgage-lending firm. The company opened a retail branch in California in 1974 and, by 1980, had 40 offices in eight states. In 1981, the pair launched a securities subsidiary, which would, specialized in the sale of mortgage-backed securities (MBSs). By 1985, Countrywide’s annual loan productions topped d $1 billion. This all took place on the backs of a booming U.S. housing market bubble which began in 1994 and ended in 2006. By the time of David Loeb’s death in 2003, the company’s annual mortgage originations reached to more than 2.5 million. The company’s financial services division originated more than 2.2 million loans totaling $408 billion by 2006. By 2007, the company had 661 branches in 48 states. Bank of America purchased the company in July of 2008 in a $4 billion all-stock transaction. How It All Started Because we live in a capitalist society, money is the driving force behind all of our daily living activities. Without money, it would be difficult to purchase much needed necessities such as food and clothes. One of the main necessities...

Words: 1470 - Pages: 6