Leslie Parrishⁱ

Overview

Taking on debt can be an important step to building wealth. For example, nearly every homeowner has purchased their home with the help of a mortgage. For the vast majority of households, home equity accounts for the majority of their net worth. Likewise, paying off a car loan or credit card bill every month can help to build good credit that can lead to good interest rates, lower insurance costs, and more credit options.

The challenge with credit used to be a lack of access—many communities and individuals were not considered credit-worthy or were barred from credit due to discrimination. Much has changed in recent years, however, and credit is generally far more abundant. Today, the key challenge is to ensure that debt taken on is responsible and suitable for the borrower so that it serves as a useful tool for building wealth, rather than stripping it away and impeding efforts to save.

Through a variety of abusive lending practices, predatory lenders systematically strip more than $25 billion from families every year. This article will summarize some loan products for short- and long-term needs. While some of these loan products—such as payday and car title loans—generally always incorporate abusive features, others—such as credit cards and mortgages—can be used responsibly if consumers know how to effectively evaluate their options.

Payday and Car Title Loans

Many families living paycheck-to-paycheck experience occasional unexpected expenses and might see emergency credit like payday and car title loans as a potential solution. Unfortunately, these products almost always lead to further financial crises.

Payday loans are typically secured by a borrower’s written check or authorization for automatic withdrawal from the borrower’s bank account. To get a loan, a borrower gives a payday lender a postdated check and receives cash, minus the lender's fees. Typically, a borrower will pay about $50 for a $300 loan. The payday lender holds the check until the borrower’s next payday, which generally falls anywhere from less than a week to a month later.

The problem with this type of lending occurs once payday approaches and the loan comes due. Most borrowers cannot pay back the entire loan in such a short period of time and still have enough left over for basic living expenses such as rent, utilities, and groceries for the coming month. These borrowers must make a decision to either (1) paying another fee to extend or rollover the loan; (2) pay off the loan and then borrow again before their next payday; or (3) default on the loan and face bounced check fees and other problems, while still owing the full loan balance to the payday lender.

There are many more payday borrowers trapped in loans than there are occasional users—over 90 percent of payday loans go to repeat borrowers who take out five or more loans a year. In fact, the average payday borrower has their loan renewed or “flipped” 8 times by a single lender, paying over $800 to borrow $340. Thus, what begins as a short-term emergency loan often evolves into a long-term, very expensive debt trap for the borrower.

Car title loans are similar to payday loans in terms of the loan amount, loan term, and cost, with one significant difference: the borrower must risk putting their car—often their only means of getting to work and most significant asset—at risk as collateral for loan repayment. A typical car title loan has a triple-digit annual interest rate, requires full repayment within one month, and is made for much less than the value of the car. Borrowers who cannot repay the full amount of the loan at the end of the month must either renew the loan by paying more fees or risk the lender repossessing the car.

As an alternative to these short-term credit products, some credit unions and other financial institutions offer small consumer loans at a much lower cost. One example of a good alternative emergency credit product is the “Salary Advance” loan offered by the North Carolina State Employees Credit Union (NCSECU). Instead of charging 300% APR or more, as most payday and car title lenders do, NCSECU charges 12% APR on a loan of up to $500. To help customers decrease their reliance on emergency credit and instead build their own savings reserve, NCSECU puts five percent of the cash advance amount into the borrower’s savings account.

If a local financial institution doesn’t offer a cheaper cash advance product, there are still other alternatives available for consumers needing help to make ends meet. Other small loan products such as a line of credit from a bank or a cash advance from a credit card can also serve as less expensive options. An employer may be willing to provide an advance on an upcoming paycheck, or a creditor may allow an extension on a payment due date or be open to setting up a repayment plan. Finally, to get long-term help for cash flow problems, a credit counselor referred by trusted sources such as the National Foundation for Credit Counseling can help consumers better manage their expenses.

Credit Cards

Another short-term credit option for many consumers is a credit card. Many credit card companies offer rewards for using their cards and making regular credit card payments can help build credit. While consumers can compare credit cards online at sites such as www.cardweb.com and www.bankrate.com , larger industry-wide changes can greatly impact the costs and benefits of using this kind of credit.

First, let's start with the good news. Many credit card companies have dropped their annual fees and—at least for their best customers—offer an array of awards and incentives to entice consumers to use their card such as 0% balance transfers, a percentage of cash back on purchases, and frequent flier miles. However, for many credit card customers, the risks of using a credit card have increased over the past two decades.

In the past, a majority of states had usury (practice of lending money at excessive rates) laws capping the interest rates and fees on credit cards at around an 18 percent annual percentage rate (APR). This all changed in the late 1970s, when a court ruled that credit card companies could charge whatever the interest rate limit was in the state in which they were located, rather than abiding by the laws of the state in which their customer resided. The effect of this ruling was a concentration of credit card companies in states with no usury laws, such as South Dakota and Delaware. Similarly, a court ruled in the mid 1990s, that credit card companies were subject to only their home state’s rules—if any—regulating the fees they could charge, regardless of the state laws where their customers live.

These two rulings have opened the door to higher interest rates and fees. For example, late fees have risen from $16 in the mid 1990s to an average of $39 now. Many credit card companies have also sought to increase income from late fees by getting rid of grace periods and mailing statements closer to their due dates. Further, instead of an 18% APR cap, many customers are now charged between 20-30% APR. Consumers are also more likely to now face rising interest rates on both their current balance and future purchases through a practice called “universal default.” Most credit card companies will raise a customer’s interest rate if they have been late or missed a payment on any bill, even if they diligently pay their credit card on time. Finally, the minimum payment a customer is expected to pay each month has decreased from 5% of their overall balance to 2-3%. While it is better to pay off the entire balance every month and avoid interest charges altogether, at a minimum, consumers should be aware that only paying the minimum can be extremely costly over time.

Mortgage Loans

With the proliferation of credit, homeownership opportunities have expanded significantly as mortgages have become more widely available to borrowers with weaker credit histories. Unfortunately, opportunities have also expanded for predatory lenders to strip home equity that families have acquired over a lifetime of making mortgage payments. Most of these abusive practices occur in the subprime market—which provides home loans for people with impaired or limited credit histories, or other factors that may disqualify them from receiving prime loans. While not all subprime loans are predatory, nearly all predatory loans are subprime. The following are several features that consumers should look out for when purchasing a home or refinancing an existing mortgage:

Excessive fees. On competitive home loans, total lender fees commonly are no more than one percent of the loan amount. Predatory lenders often tack on fees of five percent or more.

Pre-payment penalties. Predatory mortgage loans almost always carry a penalty for paying off or refinancing the loan early. These penalties often lock borrowers into high-cost loans for more than three years. The fee that must be paid to get out of the loan early can be the equivalent of six months’ interest or more.

Kickbacks to brokers. Mortgage brokers can be paid “yield spread premiums”—a kickback—when they sell a loan with an inflated interest rate to a borrower, giving them an incentive to sell a more costly loan.

Loan flipping. Lenders “flip” a loan by refinancing it to generate income for themselves, while not providing any real benefit for a borrower. Since each refinancing has high fees, significant equity can be stripped from the home.

Steering. Borrowers can be “steered” into higher-cost subprime loans when they actually qualify for a lower-cost subprime or prime loan.

Targeting. Mortgage brokers and lenders who heavily market sub-prime loans often target low-income neighborhoods and communities of color.

Another emerging area of concern is whether mortgage brokers approve borrowers for affordable and suitable mortgage products. For example, adjustable rate mortgages or “ARMs” generally offer a lower “teaser” interest rate for the initial years, with adjustments at regular intervals that can lead to higher monthly payments. While lenders generally approve borrowers based on whether they are financially able to make payments during the initial, lower-cost years of the mortgage, consumers considering ARMs need to determine whether they can make monthly payments both now and once the ARM adjusts to a higher interest rate. In addition to ARMS, another trend that is causing concern is the widespread usage of no documentation (“no-doc”) or stated income (“stated-doc”) loans. These products were initially designed with self-employed borrowers or others with complicated income flows in mind, but are now used to get borrowers approved for larger loans they would not otherwise qualify for based on their income.

What Can Be Done to Stop Predatory Lending?

Practitioners can help with efforts to reign in predatory lending by educating their communities about various loan products and financial basics such as learning to budget, building a savings reserve, and shopping around for credit. At the Center for Responsible Lending, we are working to bring about changes in state and federal laws and regulations, as well as industry practices, which will help consumers access appropriate credit products and stay on the path towards saving and building wealth.