Abusive or Unfair Lending
Practices
There are
many lending practices which have been called abusive and labeled with the
rather ominous term of predatory lending. There is a great deal of dispute
between
lenders and consumer groups as to what
exactly constitutes unfair or predatory practices, but the following
points of view are the ones that have been commonly cited.
o Risk-based pricing is the practice
of charging more in the form of higher interest rates and fees, for
extending credit to borrowers identified by the lender as posing a greater
credit risk. The lending industry argues however, that risk-based pricing
is a legitimate practice, since a greater percentage of loans made to less
creditworthy borrowers can be expected to go into default. Hence higher
prices may be necessary to obtain the same yield on the portfolio as a
whole. Certain consumer groups argue that risk-based pricing is an excuse
for extorting money from vulnerable consumers. They argue that higher
prices paid by more vulnerable consumers cannot always be justified by an
increased credit risk.
o There can be situations where the
loan price is negotiable, but the buyer is not aware of this. Many lenders
do negotiate the price structure of the loan with borrowers and in some
situations, borrowers can even negotiate an outright reduction in the
interest rate or other charges on the loan. Consumer advocates argue that
borrowers especially, but not only unsophisticated borrowers are not aware
of their ability to negotiate that they could exercise, and might even be
under the misinformation that the lender is placing the borrower's
interests above its own. Thus, many borrowers do not take advantage of
their ability to negotiate.
o Single premium credit insurance is
the purchasing of an insurance that will pay off the loan in case the
homebuyer dies. This is more expensive than other forms of insurance since
it rarely involves any medical checkups, but customers almost always are
not shown their choices. This is because usually the lender is not
licensed to sell other forms of insurance. In addition, this insurance is
generally financed into the loan which causes the loan to be more
expensive, but at the same time encourages people to buy the insurance
because they do not have to pay up front.
o The most common complaint however,
is that with any loan has associated fees which do not add to the annual
percentage rate or APR number. These are compared to a hypothetical
situation where in the same money can be borrowed without fee from a
parallel line of credit. For instance, a payday loan of 30 USD may cost 3
USD. If the borrower only had a credit card, a cash advance on the credit
card might cost 5 USD, and hence the payday loan would be the cheaper
option, unless what I need to purchase could be purchased by the credit
card incurring no cash advance fee. However, if the borrower had a line of
credit with no fees for cash advances, then if he borrowed that 30 USD and
repaid it within the same time frame as the payday loan, the interest
would only cost 0.03 USD. This causes people to suggest that the 3 USD
charged on the 30 USD is in reality a 1000% interest rate.
However it might be
impossible for the borrower to obtain a no fee line of credit; this
scenario occurs in many places like:
" Payday loans
" Credit Card late fees
" Certain mortgage and equity loan fees
" Rent to own
stores
" Checking Account Overdraft Fees
" Tax Refund
Anticipation Loans
" Car Dealer Finance, where the price of the car
if financed is higher than if paid for in cash
Anti-predatory lending
organizations such as Association of Community Organizations for Reform
Now or ACORN argue that predatory loans are usually made in poor and
minority neighborhoods where better loans may not be readily available,
and that the loss of equity and foreclosure can thoroughly devastate
already fragile communities.
Other organizations
such as the American Association of Retired Persons or AARP, Inner City
Press and ACORN have worked hand in hand to stop what they describe as
predatory lending. ACORN for instance has targeted specific companies such
as Household Finance and H&R Block, successfully forcing them to
change their practices. Inner City Press and Fair Finance Watch continue
watch-dogging the practices of institutions like HSBC and Citigroup as
they export their controversial sub-prime lending models beyond the United
States. These groups have also spearheaded amendments to the legislation
that would clarify forms of lending deemed to be predatory
illegal.
On the other side of
the issue are various sub-prime advocates such as National Home Equity
Mortgage Association or NHEMA, who say that many practices commonly termed
predatory, particularly the practice of risk-based pricing, are not
predatory in reality.
Underlying
Issues
There are numerous
underlying issues in the predatory lending debate of which these are a few
viewpoints:
o Competition: Some of those who
believe that the practice of risk based pricing is fair, nevertheless feel
that many loans which they deem predatory charge prices far above the
risk, and use this risk as an excuse to overcharge. Others counter that
competition would reduce this possibility. These criticisms may be applied
to only certain products and not most others.
o Financial Education: Many observers
do feel that competition in the markets served by what critics describe as
predatory lending is not affected by price because the targeted consumers
are completely uneducated about the time value of money and the concept of
annual percentage rate or APR, a different measure of price than what many
borrowers are used to.
o Risk Based Pricing: The first issue
that is to be addressed is as to whether risk based pricing is fair in and
of itself. This is the term used to refer to the universal practice of the
bond markets and the insurance industry, and is implied in the stock
market and in many other industries. The basic idea is that those who are
more likely to default, or are considered more risky, should pay more
interest to avoid the tragedy of the commons and hence to avoid unfairly
punishing those who have never defaulted and never will. This might be the
reverse way of looking at it though, since there is another stream of
thought that risk-based pricing can also be seen as a way for a lender to
lend to a group they never have been able to previously, whereby the
higher charge allows them to not lose money based on the higher than
normal default rate. There is a lot of debate as to whether this concept
is fair. There are also some who, while agreeing that the rates are
generally set fairly, relative to the risk the lender assumes, feel that
it is they must instead disallow borrowers with credit problems from
taking out such a loan.
o Caveat Emptor: There is an unending
debate as to whether or not a lender should be allowed to charge whatever
it wants for a service, even if it seems to make no attempt at deceiving
the consumer about the price. At the outset, there is the belief that
lending is a commodity and that the lending community has almost a
fiduciary duty to advise the borrower as to how to obtain funds more
cheaply. Also on debate are certain financial products which appear to
only be profitable due to an anti-adverse selection, which is a lack of
knowledge on the part of the customers as compared to the lenders. For
instance, some people allege that credit insurance would not be profitable
to a company if only those customers who had the right fit qualifications
in terms of eligibility criteria and low risk levels, for the product they
actually bought, or for instance, only those customers who were not able
to get the generally cheaper term life insurance.
o Discrimination: Certain groups feel that many financial
institutions continue to engage in racial discrimination when it comes to
disbursement of loans. Most do not allege that the loan underwriters
themselves discriminate, but rather that there is an inherent
discrimination in the underlying system. Loan brokers or other types of
lending situations where the rate is negotiable or set by the salesman
himself, however, have been seen as more likely to discriminate and it has
boiled down to, in reality, certain lenders like Honda Auto Finance having
had to pay settlements for alleged discrimination of their auto dealers.
The discrimination that might occur in such a scenario is usually thought
to be in this way: the loan broker would more often claim that a racial
minorities' credit score is lower than it really is, justifying a higher
interest rate charged, with the hope that the customer would readily
assume that the lender was right because of an internalized bias that a
minority group has a lower economic profile. It is also possible that any
broker or loan salesman with some control of the rate charged would simply
attempt to charge a race that he is prejudiced against, a higher rate.
This however has been seen to be a less likely scenario, although the
potential for the occurrence of this causes some to call for the outlawing
of interest rates being set by every thing but non objective
measures.
