What is predatory lending?

Difficult economic times can bring out the best and the worst in business practices. While some industries, like restaurants and retail companies, struggled to survive during the pandemic, others raked in record profits. For example, payday lenders (who offer short-term loans with high interest rates) made millions of dollars in 2020 — but some argue those earnings came at a cost to consumers’ financial livelihoods.

If you’re searching for personal loan options, make sure to look out for red flags that could be signs of predatory lending. Predatory lenders use deceptive practices to get potential borrowers to take out loans that aren’t right for them. A predatory loan might sound great because it’s fast, doesn’t require money upfront and can go toward whatever you want, but you don’t want to get into a debt cycle you can’t recover from.

Predatory lending definition

Predatory lending is any lending practice that uses misleading or unethical tactics to persuade borrowers to take out loans that aren’t in their best interests.

These loans often come with extraordinarily high fees and ambiguous terms. A lender might take advantage of borrowers in desperate situations by hiking up interest rates or fees, and some borrowers will accept these unfair terms because they need funding ASAP.

Often, the victims of predatory lending are older people and individuals with lower incomes. However, it’s easy for anyone to sign loan agreements without understanding the terms completely, and many borrowers end up paying more than they intended.

For instance, you could end up paying “late fees” even when you know you paid on time, like one reviewer from California. This is why it’s important to familiarize yourself with all the terms of your agreement.

Predatory lending practices

There’s no polite way to say it: Predatory lenders prey on individuals in distress and those who aren’t aware of their consumer rights. More often than not, these practices leave people who are already struggling in even more of a financial mess.

Fortunately, there are ways to spot an unethical lender. Here are eight common predatory lending practices to watch out for. Not all are sure signs of a predatory lender, but be aware if you see any of them.

1. High interest rates

Charging interest rates in the triple digits is predatory and puts consumers in a position to fall more into debt they can’t repay. Most payday loans, which are short-term loans that are expected to be repaid within a few weeks (usually by the next payday), have exorbitant interest rates — but they’re often a borrower’s only option.

Many payday loans charge the equivalent of a 400% interest rate, according to the CFPB.

Payday lenders may present interest rates as a fee per dollar borrowed rather than as a percentage. This can be confusing and lead you to accept a loan with above-average interest rates. According to the Consumer Financial Protection Bureau (CFPB), payday loan lenders commonly charge fees of $15 for every $100 borrowed, which equals a 400% interest rate for a two-week loan. To compare: Most personal loans have annual percentage rates (APRs) ranging from just 6% to 36%.

2. Exorbitant fees

Predatory lenders may also charge excessive fees. A mortgage lender, for example, could disguise additional fees as administrative or loan origination fees. Payday loans may involve additional rollover fees (to extend the due date of your payment) and late fees. These charges are high to begin with, but lenders can also charge them multiple times throughout the life of the loan.

There are laws to protect you from overpaying in fees, though, like the Dodd-Frank Wall Street Reform and Consumer Protection Act, which limits mortgage points and fees to 3% of the loan amount for Qualified Mortgages (mortgages that comply with the consumer protection requirements of the Dodd-Frank Act).

3. Prepayment penalties

You may be charged prepayment penalties if you repay your loan ahead of the repayment schedule. Typically, you only need to worry about these fees if you pay back the total within the first few years of starting the loan.

Some government-backed loans, like USDA and FHA loans, are prohibited from having prepayment penalties. Personal loans, on the other hand, may have early payoff fees, but this will vary by lender.

4. Balloon payments

A balloon payment, a large lump-sum payment due at the end of the loan term, is a common tactic used by predator lenders. Loans with balloon payments entice borrowers with low monthly payments, but when the lump sum is due after a few years, it’s likely that the borrower won’t be able to afford it and will have to refinance the remaining balance (which comes with additional fees and closing costs).

5. Loan flipping

Loan flipping is when a lender persuades you to refinance your loan repeatedly (which basically means starting a new loan each time). The lender might present this option as a way to save on interest or reduce your monthly payment. The catch: New loans come with additional fees and charges.

6. Lack of transparency

Some lenders confuse borrowers by presenting cost information in a difficult-to-read format. If a lender isn’t upfront about the costs of a loan, you won’t have all the information you need to make a sound decision. Lack of transparency, especially about fees and charges, is a red flag.

All fees and charges should be detailed in writing for you to review before signing the loan agreement. The Truth in Lending Act requires lenders to give borrowers the loan terms (like APRs, finance charges, loan principals and payment totals) in a standardized format so they’re easy to compare with other loan options.

7. Requiring autopay

If you are required to sign up for automatic payment withdrawals to get a payday loan, you may be dealing with a predatory lender. Once lenders have this information, they may be able to withdraw from your account at inconvenient times, which can sink you further into debt if you’re charged overdraft fees for multiple withdrawal attempts.

Lenders are generally prohibited from requiring you to set up autopay drafts from your checking account to get a loan, although some reputable lenders offer lower APR rates for borrowers who do use autopay.

8. Negative amortization

With most loans, you make fixed monthly payments that include contributions to both principal and interest (called loan amortization). Since interest is calculated as a percentage of the principal, the more you pay off the loan, the less interest you’ll owe each month.

However, some lenders only require that you pay interest each month, which means you aren’t working to pay off the principal as you go. And if you pay only a portion of the interest owed, your loan balance will continue to grow over time. This is called negative amortization, and it can lead you down a path of debt and bankruptcy if you can’t pay down the loan. The loan balance will continue to snowball into an unmanageable amount of debt.

Predatory lending examples

Payday loans are often considered predatory due to their high interest rates and the way they appeal to people in desperate financial situations.

Car title loans also tend to come with high interest rates, and with a title loan, the lender holds the car’s title as collateral for the loan. If the borrower doesn’t pay back the loan, the lender could take ownership of the vehicle. As with payday loans, some states have outlawed title loans or set restrictions on who can qualify.

Other examples of predatory lending often include subprime mortgages and balloon mortgages. While these types of mortgages aren’t generally illegal (though they are heavily regulated following the 2008 financial crisis), they carry a high risk for the borrower.

How to report predatory lending

Several federal and state laws are in place to protect borrowers from predatory lending practices. For example, multiple states have outright banned payday loans or set limits to make them less predatory, including Arizona, Arkansas, Connecticut, Georgia, Maryland, Massachusetts, New Jersey, New Mexico, New York, North Carolina, Pennsylvania, Vermont and West Virginia.

Federal regulations that protect consumers include the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the CARD Act), which limits the fees and charges lenders can impose, and the Home Ownership and Equity Protection Act of 1994 (HOEPA), which prohibits deceptive lending practices in refinancing and home equity lending.

If you suspect that a lender has acted unfairly or illegally, you can file a complaint with the Consumer Financial Protection Bureau online or by phone. Often, you can also submit a report to your state’s attorney general. It’s important to report companies engaging in predatory lending practices because they’re likely to continue preying on others in the future.

Bottom line: How to avoid predatory lending

The most effective way to avoid falling victim to a predatory lender is by educating yourself on your rights and the regulations that protect you. Never sign a loan agreement in haste without reading it fully and understanding the terms first. Be sure to talk to your loan officer if you have any questions — a reputable lender will take the time to ensure you're comfortable with the loan terms.

Learn to spot the red flags of unfair lending practices (like a lack of transparency regarding fees), and be ready to walk away from any lender that doesn’t disclose the information you need to make a sound decision. Finally, gather quotes from different lenders to ensure you get the best deal available to you.