What Is Predatory Lending, and How Can You Spot It?
Predatory lenders look to feed off your finances and can cause significant damage. Here’s how to spot them.
Contributing Writer at Tally
October 12, 2022
Many legitimate lenders exist to help people buy a house, purchase a car, start a business or consolidate debt. They offer creditworthy borrowers fair loan terms and sincerely look to help people while profiting off the reasonable fees and interest rates they charge.
However, another type of lender exists that looks to profit excessively off borrowers by offering unfair loan terms, high interest rates and more. This is predatory lending and can lead to long-term financial damage if you fall victim to it.
Below, we outline what predatory lending is and what signs to look for to help you avoid falling victim to these financial predators.
What is predatory lending?
Predatory lending is a broad term that defines a lender that imposes unfair, abusive or deceptive lending terms upon its borrowers. These can include charging high interest rates, levying excessive fees, reducing a borrower’s equity or even placing a borrower with good credit in a lower-credit tier, leading to a more expensive loan.
In every case, these tactics are unfair to the borrower and work to the financial institution’s benefit.
An example of a predatory lender would be a payday lender that offers a short-term loan in return for a lump-sum payment plus interest and fees when you get your next paycheck. You may borrow only $200 from this lender to cover bills, but the lender charges you $50 in fees to lend you this cash until your paycheck comes next week.
This may seem like a relatively low-cost loan, but that $50 in fees is equivalent to an over 700% annual percentage rate (APR).
Another example is a lender that not only issues you a sky-high interest rate but also has sketchy collection tactics, such as threatening you with a lawsuit or violence if you fail to pay.
What predatory lending signs should you look out for?
When looking for loan options, you should look for certain tactics common in predatory lending. Predatory lenders come in all shapes and sizes and offer all types of loans, including personal loans, auto loans and home equity loans. They can even be mortgage lenders.
Below, we’ll highlight some of the tell-tale predatory lending practices.
A balloon payment is a large lump-sum payment at the end of a loan term. According to the Consumer Financial Protection Bureau (CFPB), a balloon payment is typically at least double the normal monthly payment amount.
Lenders use this tactic to keep your monthly payments low during the life of the loan, but this lump sum can cause issues in the end. If you can’t afford the balloon payment, you may need to refinance the loan and incur more fees or default on the loan.
Balloon payments aren’t always predatory actions, though. It’s not predatory as long as the lender is upfront about the balloon payment and offers alternative loan options.
Loan flipping is when lenders constantly pressure borrowers into refinancing their loans multiple times. This leads to more fees for the lender and can get the borrower tied up in fee-riddled debt that they may struggle to get free from.
Payday lenders are known for this tactic, as borrowing against future pay can leave you short of cash once your check arrives. So, the lender pressures you to take out a payday loan to pay off the original loan, putting you into a vicious cycle of debt.
Loans come with fees. That’s how lenders make money — in addition to the interest they charge. But some lenders are too aggressive with these fees. High fees are early indicators of predatory lending.
On most loans, you can typically expect an origination fee in the 1% to 10% range and a $25 to $50 application fee. As for a mortgage loan, you can expect all your fees to total 3% to 6% of the home’s value. If you run into a loan with fees well exceeding these averages or fees that you don’t often see today, such as prepayment penalties, there’s a good chance you’re dealing with a predatory lender.
Equity stripping or asset-based lending is another predatory lending practice. This is when a lender bases a loan on an asset you have rather than your creditworthiness. For example, lending you cash but placing a lien on your vehicle or home to secure the debt.
This not only reduces the equity you have in your vehicle, but you also risk losing the vehicle or home to foreclosure if you default on the loan. Common targets for this practice are retired people who own their homes. As homeowners, these retirees have a lot of equity, but they also have limited cash, making them relatively easy targets.
When you have good credit, you should receive loan offers to match your credit report and credit score. A common predatory lending practice is to steer folks with good credit into subprime lending options with high interest rates and high costs. The lenders never bother offering these borrowers the prime loans their credit history and income qualify them for.
Loan steering targets are generally people with limited experience in credit who don’t realize they can qualify for better loan terms.
Adding unnecessary items
Lenders often partner with other companies to offer additional services on top of their loans, such as life insurance, disability insurance or credit insurance. This is all well and good if they are offered and not sneakily added to your loan.
For example, a mortgage broker may offer you a term life insurance policy to cover your mortgage if you die and show you how the premium will impact your monthly payment. This is perfectly acceptable as long it’s presented clearly and offered as an option.
It slips into the predatory-loan realm when a lender adds these options to your loan amount without consulting you and presents it as part of the loan itself. If you don’t carefully review the loan terms, you can easily fall for this tactic, as a predatory lender will not point out the add-ons or give you the option to remove them.
Is a buy now, pay later (BNPL) a type of predatory lending?
BNPL is a lender that offers short-term financing with no credit check. These lenders allow shoppers to purchase items today and pay them off over a few weeks, often without interest.
For example, you want to purchase a $200 bicycle but lack the funds to pay the total amount now. A BNPL lender will allow you to buy the item today and break the cost into four equal biweekly payments. The first payment of $50 is due today, with three more payments of $50 each every two weeks.
While these loans generally have no interest rate and little to no fees, they can still be a form of predatory lending. Here’s why they fall into this realm.
Targeting low-cash buyers
BNPL lenders cater to shoppers who don’t have the liquid cash to make a purchase. They allow shoppers to leverage future income over a short term, which could result in later financial struggles if they don’t have the cash to make the biweekly payments.
A financial struggle like that could result in the borrower taking out additional loans to cover their expenses when the $50 biweekly payments make them fall short of other bills. So, even though the BNPL lender isn’t initially partaking in predatory lending practices, the fact that they cater to individuals with limited cash and leverage future income can push them into this category.
Charging big fees and interest
On top of targeting people with limited cash, BNPL lenders have a darker underbelly than their no-interest, no-fee outward appearances lead you to believe. This all comes to a head if you miss a payment. When this happens, you’ll get hit with a late fee, and some BNPL lenders will start charging you up to 30% interest if you fall behind.
Lending rules don’t apply
Have you ever wondered why BNPL lenders typically offer four-payment loans? There’s a good reason for that. By offering only four-payment terms, these lenders aren’t subject to the five-installment trigger regulated by the Truth in Lending Act (TILA).
The TILA is key legislation designed to protect consumers from deceptive lending by requiring lenders to disclose all loan costs so you can comparison shop and avoid falling victim to predatory lending. It also protects borrowers from inaccurate and unfair billing practices.
The fact that these lenders purposefully offer only four-payment loan plans to remain out of the TILA’s purview is a serious red flag.
Instead of giving in to your impulses and using a BNPL lender to get an item today, try saving the estimated biweekly payment in a separate savings account until you have enough to pay for the item in full.
Predatory lenders are on the prowl, but you can avoid them
Predatory lending remains an issue, but you can avoid these lenders by watching out for tell-tale predatory lending practices and carefully reviewing all lending terms. Don’t be afraid to question anything that looks out of the ordinary on a loan document and remember to read everything before you sign.
If credit card debt has caused financial hardships for you, don’t resort to predatory lending to make ends meet. Check out the Tally† debt repayment app instead. Our app manages your credit card payments, and Tally offers a lower-interest personal line of credit, allowing you to efficiently pay off higher-interest credit cards.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 to $300.