Predatory Lending: What It Is and How to Avoid

Written by Samantha CatheyReviewed by Nathan Brown, CFP®Updated: 4th May 2022
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According to Merriam-Webster, the definition of predatory is, “inclined or intended to injure or exploit others for personal gain or profit.” That kind of rhetoric does not belong in the financial industry, and you need to be on alert for unfair and deceptive sales tactics designed to pressure you into accepting unaffordable, misleading loan terms. You need to be aware of predatory lending practices to protect you and your family.

What Is Predatory Lending?

Predatory lending practices benefit the lender at the expense of the borrower. They are purposefully confusing and fail to disclose the costs and risks of a loan or loan product. Experts disagree on what exactly constitutes predatory lending, but all agree taking advantage of a borrower’s situation to perpetuate the endless cycle of debt is fundamental.

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How Predatory Lending Works

Lenders with sinister intentions seek out certain borrowers, especially if they have little knowledge about loans or are generally uneducated. Furthermore, predatory lenders prey on the poor, the elderly, and minorities going so far as to target certain neighborhoods or advertise in a certain language. People in need of immediate cash become common victims, as do those with past financial problems and a poor credit history.

What Are the Signs of Predatory Lending?

There are warning signs to avoid when seeking out a loan officer or shopping for your car or home loan. Often, predatory lenders sneak into consumers’ homes through unwanted phone calls, pieces of mail, or even showing up at the door. If it feels like you’re being sold to, it’s best to step back and assess your options.

A few key warning signs of predatory practices include loan terms that are too good to be true, so trust your instincts if something feels off. You’ve encountered predatory lending if you’re ever asked to lie about your income or employment on a form or pressured to accept less-than-ideal loan terms.

>> More: What Happens If I Default on My Personal Loan?

What Is an Example of Predatory Lending?

Education is key to safeguarding yourself against nefarious lending practices, whether you’re shopping for a certain loan or just existing in the broader financial world. Here are common examples of predatory lending.

#1. Sky-High Interest Rates

The biggest red flag for predatory lending is a triple-digit interest rate. Car title and payday loans often charge colossal rates of 400%, but anything greater than 36% is considered predatory. Ideally, the interest rate you secure will be a lot less.

Regarding interest rates, lenders are legally required to express a loan’s annual percentage rate (APR), so if your representative is hasty to disclose it, consider it a warning. APR reflects an interest rate and associated fees expressed as a percentage.

#2. Excessive Fees

Often located in the fine print, fees from predatory lenders are much higher than those from reputable institutions. Closing costs and appraisals are normal to encounter, make sure they’re a reasonable dollar figure, and if your lender avoids the question and refuses to be transparent about their fee structure, it’s best to walk away.

#3. Add-on Loan Services and Features

Also called loan packing, adding excess products to increase the loan cost is frowned upon. Packing commonly includes insisting the borrower purchase credit insurance, even when it’s not necessary.

#4. Loan Flipping

The practice of loan flipping or loan churning encourages borrowers to refinance over and over into a larger, longer loan with a higher interest rate accompanied by fees. Refinancing isn’t inherently bad and can help certain people out of debt—it just must be done the correct way.

#5. No Credit Checks

If it’s surprisingly easy to get approval by skipping a credit check, that’s a red flag. A lender who isn’t concerned about your ability to repay a loan doesn’t have your best interest in mind and is eager to capitalize on your fees.

#6. Balloon Payment

A balloon payment is one large payment at the end of a loan term significantly larger than prior payments. Usually attached to a mortgage or other amortization loan, balloon payments are risky because the final payment can be tens of thousands of dollars all at once, which can be difficult to accommodate if you’re used to paying less than half that previously.

#7. Terrible Customer Reviews and Industry Reputation

Reading reviews is beneficial to all shopping experiences, and when you’re in the market for a loan conducting your own research is pivotal. If they have a history of customer complaints, there’s no need to waste your time. Additionally, the right professional will be licensed and can prove it easily. Check out the Better Business Bureau if you’re ever unsure.

#8. Asset Based Lending

This mode of high-risk secured lending is often offered to borrowers with inferior credit by securing an asset like home equity or a car title. Instead of considering income or ability to repay, predatory lenders, attract consumers into agreeing to a loan they cannot afford. Then when they default, the lender can collect the asset like a home or car to recover costs. The Federal Trade Commission (FTC) calls this equity stripping.

Common Predatory Loans: Payday Loans, Subprime Mortgages, & Auto-Title Loans

Payday Loans

Payday loans are short-term and usually for $500 or less, but each state has its limits. Some states don’t even allow these types of lending. Why is it so bad? An average payday loan fee equates to an APR of 400%. Some fees are even more. Here’s how it works.

After you receive your loan, you’re charged with paying it back in a single payment in two to four weeks on your next payday, hence the name. To repay the loan, you write a post-dated check for the full balance plus any fees, or you give the lender permission to pull directly from your bank account on the due date. If money isn’t in your account, the lender will still cash your check or pull funds, thus creating a negative balance and multiple fees. According to the Consumer Financial Protection Bureau (CFPB), most borrowers renew their loans so many times they pay more in fees than they originally borrowed.

Subprime Mortgages

Most credit reporting agencies classify subprime borrowers as individuals with credit scores below 650. Subprime mortgages are peddled to people with a poor credit history and a high likelihood of defaulting on their loan, especially in part because their loan terms offer them much higher interest rates than consumers with good credit scores would be offered.

Subprime mortgage lending was a huge catalyst in the 2008 financial crisis, and despite its poor reputation due to it, subprime lending is making a comeback. However, some states have laws curbing high-interest rate loans, while the CFPB monitors predatory lending nationwide.

Auto-Title Loans

Illegal in many states, an auto title loan is a small, secured loan that uses a car for collateral. Ranging from $100 to $5,000, these loans are based on a percentage of the car’s value which you must fully own or have equity in. You hand over your car’s title in exchange for a loan, and you get it back once you’ve paid everything off. Also called “pink-slip loans,” auto-title loans have high fees and interest rates translating to 300% or more. If you cannot repay the loan, your car may be repossessed.

Is Predatory Lending a Crime?

Not all predatory lending practices are criminal, but they all cause severe financial hardship and stress. It starts and keeps consumers in the cycle of unmanageable debt, leading to ruined credit or even homelessness.

Federal laws provide some protection to consumers, most notably through the Equal Credit Opportunity Act, making it illegal to charge higher interest rates based on an applicant’s race, color, religion, sex, age, marital status, or national origin.

>> More: Learn About the Best Ways to Borrow Money

Bottom Line: Predatory Lending

If you’re tempted by payday loans or auto-title loans to get cash fast, talk with a financial advisor, seek a credit union or get credit counseling. There’s no shame in needing cash for necessities, but there are better ways to secure it.

Remember, a trustworthy lender will lead you through the entire process, share their credentials, and clearly explain the fee structure. Fees and interest rates do vary, even between the good guys. As always, read the fine print on your documents and sign only when you fully understand the terms.

Samantha Cathey
Samantha Cathey

Samantha Cathey is a Senior Personal Finance Writer & Product Analyst with years of financial training and industry knowledge. She is a former banker, loan officer and investment advisor before dedicating her energy to helping individuals more creatively, through her writing. Samantha studied at the University of Idaho where she majored in Journalism and Writing. Her areas of expertise are mortgages, credit cards, loans, and investing.