Predatory Lending: The Definition And How To Avoid It
Miranda Crace6 minute read
UPDATED: July 26, 2023
Many lenders want to provide good service for their clients and give them the financial help they need. However, this isn’t the case with predatory lenders, who will try to exploit borrowers for their own financial benefit.
To help you spot predatory lending before it’s too late, we’ve broken down the most common predatory practices and loans to watch out for, as well as safe alternatives for you to explore.
What Is Predatory Lending?
Predatory lending is when a lender uses deceptive, unfair and abusive practices to coerce borrowers into taking on loans they can’t afford. Victims of predatory lending can be so burdened by their debts that they struggle to manage their other monthly expenses.
Predatory lenders will often target borrowers who have a low credit score and low income, and therefore have fewer loan options available to them. These lenders often use aggressive and high-pressure sales tactics that prey on a borrower’s lack of experience or understanding with regard to lending transactions.
Common Predatory Lending Practices
Lenders who rely on predatory tactics are primarily out to earn a profit, regardless of a borrower’s ability to repay a loan. Common predatory lending practices may include:
- Lack of transparency: Predatory lenders may intentionally fail to disclose important information pertaining to your loan, such as the annual percentage rate (APR). They may also disclose false information initially to get people to sign on with them, leaving the borrower to discover the truth only after it’s too late.
- High fees and interest rates: Most predatory loans – especially those that don’t require a credit check – come with high lending fees and interest rates. Short-term loans may also charge high rollover fees, expecting that borrowers won’t be able to repay the debt on time.
- Bait-and-switch schemes: A predatory lender can promise certain loan terms and without warning, change to more expensive terms. In some instances of a bait-and-switch, a higher interest rate will go into effect just months after borrowers have started making loan payments.
- Loan packing: Predatory loans can come with unnecessary add-ons that are “packed in” without the borrower’s consent. A common example of loan packing is charging the borrower for credit insurance, which is meant to pay off the loan if the borrower dies.
- Loan flipping: A predatory lender may try to convince a borrower – even multiple times – to refinance their loan for a longer term and higher interest rate. Refinancing, or “flipping,” a loan will incur additional fees, and potentially mortgage points (used to lower interest rates), every time it’s done.
- Asset-based lending/equity stripping: Also known as secured loans, asset-based lending requires a valuable asset be offered as collateral if a borrower fails to repay the loan. A lender can also use a borrower’s home equity as collateral, and the borrower risks losing their home through foreclosure if they fail to make their payments.
- Balloon payments: Lenders can promise low monthly payments at first but charge a large “balloon payment” at the end of the loan term as a hidden cost. If a borrower can’t make that final payment, they may have to refinance and pay additional fees and costs.
- Prepayment penalties: Another commonly hidden fee that predatory lenders impose is a prepayment penalty, which charges a borrower for paying off their loan before the end of the term.
Types Of Predatory Loans
Predatory lenders can deal in all types of loans, including mortgages and personal loans. Certain loans, though, tend to naturally put more power in the hands of the lender at the borrower’s expense. Below are some common predatory loans you may encounter:
A payday loan is a short-term loan often offered without a credit check and with immediate funding. The loan is typically due to be repaid by the date the borrower receives their next paycheck, which can be 1 – 2 weeks from the loan’s approval.
Payday loans are seen as predatory because of their high fees and interest rates. APRs for payday loans can run 390% or more, and lenders can charge fees of 10 – 30% for every $100 borrowed. Borrowers who choose to roll the loan over will be charged an additional lending fee. The shorter term, too, can lead to constant rollovers and trap borrowers in a debt cycle.
Auto Title Loans
A title loan, most often called an auto title loan, is a short-term loan secured by the title of a borrower’s vehicle. Most repayment periods last only 15 – 30 days, with a 25% monthly interest rate (or an APR of 300%). If the borrower can’t make their payments and must roll the loan over, that’s an additional 25% charge. Defaulting on the loan allows the lender to take the borrower’s vehicle, so there’s more at stake than just your finances.
Pawn Shop Loans
Pawn shop lenders, or pawnbrokers, also take collateral in lieu of a credit check to secure a loan. This collateral often comes in the form of a valuable item like jewelry that will sell in the store if the borrower defaults. The rates and terms can differ between pawn shops, but the APR for a pawn shop loan is typically around 200%.
While not predatory by nature, subprime lending can easily put a borrower in a tough financial spot while the lender benefits. Lenders often offer subprime loans to applicants with poor credit and a high debt-to-income (DTI) ratio, but these loans come with higher interest rates to make up for the risk to the lender. Predatory lenders may try to steer borrowers and home buyers who don’t know any better into taking on a subprime loan.
Homeowners with subprime mortgages suffered the most during the Great Recession between 2007 and 2009, accounting for a disproportionate percentage of defaults and foreclosures during this time.
How To Avoid A Predatory Lender
Now that you know what to watch out for, take these additional steps to protect yourself from predatory lending:
- Shop around and compare different lenders. Getting prequalified can show you what rates and terms you’re eligible for based on your credit and DTI.
- Be wary of no-credit-check and same-day loans. These will usually come with higher fees and interest rates.
- Ask a lender questions about the loan terms until you fully understand what you’re signing up for.
- Look into a lender’s reputation and feedback, such as online reviews and word of mouth.
FAQs About Predatory Lending
What is an example of predatory lending?
If you take out a $500 payday loan that charges 15% for every $100, you’ll pay a lending fee of $75. If you roll the loan over, that’s another $75. Added together, that’s an additional $150 in fees, meaning you’ll pay back $650 total. Continuous rollovers will add another $75 on every time you do so.
Is predatory lending illegal?
While morally wrong, predatory lending isn’t technically illegal in many cases. Organizations like the Consumer Financial Protection Bureau (CFPB) are taking measures to better protect borrowers from predatory lending schemes and excessive interest rates, such as their Payday Lending Rule.
How do I report predatory lending?
Predatory lending practices should be reported to your local office of consumer affairs or state Attorney General. You can also file a report with the Federal Trade Commission (FTC).
Safer Alternative Lending Options
If you’d rather tread safer waters, consider these alternative financing options:
A personal loan is an unsecured installment loan, meaning it doesn’t require collateral and you can repay it through a series of monthly payments. The prequalification and application process for personal loans requires credit checks to determine what your interest rate will be, and approval and funding can be completed in 1 – 7 business days. Rocket Loans℠ can even offer same-day funding in certain cases.*
Credit cards can have higher interest rates than personal loans – the average rate hovering between 6 and 36% – but if you can keep up with your payments and borrow from a trustworthy card issuer, you can avoid the fees and APR of more predatory loan types.
Some financial institutions will also offer 0% APR introductory periods for new cards, where you can make interest-free payments for a limited time that’s usually 12 – 18 months. Additionally, a credit card can allow you to take out a cash advance for a quick, no-credit-check loan.
Borrowing From Others
One of the simpler borrowing options is to ask a friend or family member for cash. Depending on the amount of money being lent, and the trust between those involved, this type of lending can leave out credit checks, interest rates and repayment plans entirely.
Building an emergency fund over time can give you financial aid when you need it, and without the worries of repayment, interest rates and lending fees. You’ll want to start saving up ahead of time, though, so you can have what you need when an emergency happens.
Final Thoughts: Don’t Fall For Predatory Lending
A lot of trustworthy lenders want to work with you to provide the funding you need, but it’s important to be able to tell the good lenders apart from the predatory ones. Recognizing predatory lending practices can help you avoid them when shopping around, and you can consider safer lending options if they’re available to you.
For a personal loan you can trust, get prequalified today with Rocket Loans to see your eligible rates and terms.
*Same day funding is available for clients completing the loan process and signing the Promissory Note by 1:00 p.m. ET on a business day. Also note, the ACH credit will be submitted to your bank the same business day. This may result in same day funding, but results may vary, and your bank may have rules that limit our ability to credit your account. We are not responsible for delays that may occur due to an incorrect routing number, an incorrect account number or errors of your financial institution.
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