Banks trick poor into expensive loans
This article is from the January/February 2000 issue of Dollars and Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org/archives/2000/0100bradley.html
This article is from the January/February 2000 issue of Dollars & Sense magazine.
at a 30% discount.
Laid off after 29 years of working for a local telephone company in North Carolina, "Roberta Green" was struggling. Although she had a part-time job driving a school bus, she was not earning enough to pay her bills. When she received a call from a man who said he could help her come up with some cash, it seemed like a godsend. The man said he worked for a home improvement company and that he could find her a loan that would both pay for some remodeling on her house and leave enough cash left over to pay her bills.
Unfortunately for Green, the salesman actually worked as a mortgage broker for American Mortgage, and he was not peddling home improvement, but a refinancing of her existing home mortgage at a high interest rate. He invited Green to his office, where he chatted with her while he filled out a mortgage application for her. While he indeed gave her a "good faith estimate" — a form required by regulators that lists the proposed interest rate and fees on a loan — the loan he wrote up was not a home equity loan for the $6,000 she needed to pay off bills. It was a loan for $76,500 that refinanced her entire mortgage at a higher interest rate.
A couple of weeks later Green signed the loan papers and walked out with a check for $1,900. The signing went by so fast, Green didn't catch all that was written on the pages. But she trusted the broker and the lawyer in the room, and felt she had a pretty good grasp on what she was signing.
What Green didn't realize was that her loan terms had changed since she received that good faith estimate. The broker had added $6,500 in fees to her loan, and changed the loan from a fixed-rate to a more expensive adjustable-rate mortgage. Green was a victim of predatory lending.
Predatory lending is any unfair credit practice that harms the borrower or supports a credit system that promotes inequality and poverty. One of the most common predatory practices is placing borrowers into higher interest rate loans than their credit risk would call for. Although they may be eligible for a loan in the so-called "prime" market, they are channeled into more expensive and fee-padded loans in the "subprime" market supposedly just for credit risks. The result: financial services companies end up padding their profit margins by draining away the equity borrowers have built in their homes over the years. Unfortunately, unless a company discriminates against members of a minority group, the elderly, or others protected by law, predatory lending is legal in all states except North Carolina.
Predatory lending is becoming more of a problem as the home mortgage market undergoes rapid change. Banks — the sector of financial services that control the lower interest "prime" market — are issuing a declining share of home mortgages, and the subprime market is booming. The line between consumer finance — including credit cards and small home improvement loans — and home mortgages is blurring as homeowners borrow against their houses to consolidate their debt.
And companies are increasingly using computers to determine credit risk, but in ways that make predatory lending even easier. Credit scoring is a process in which information about a borrower's income, credit history, and job history is fed into a computer program that calculates the borrower's risk of default on the loan. Theoretically, the higher the score a borrower receives, the better credit risk she is, and the lower the interest rate she should receive. Under law, credit scoring should be race-blind, and should insure that similarly situated white and minority borrowers receive similar mortgage rates. However, individual lenders charge wildly different rates for the same score. Mortgage brokers and loan "originators" on the staffs of banks or mortgage companies are often paid incentive commissions for placing borrowers into rates higher than the risk-based price that the underwriting guidelines call for.
Those most hurt by the growing subprime market are black and Hispanic borrowers like Green, who is African American. A September 1999 study by the Department of Housing and Urban Development shows that since 1994, conventional, prime lending to black and Hispanic borrowers has dropped, and that black borrowers are increasingly being turned down for prime rate loans in numbers that far outstrip whites. The same study shows that lending by subprime companies to minorities is on the rise. Not all subprime lending is predatory; higher credit risks are normally charged higher interest on loans. But the growth in subprime lending to minorities, when coupled with the decrease in prime lending, leads to concerns that minority borrowers with good credit are being shut out of conventional markets, and channeled instead into more expensive, subprime loans.
Good subprime lending to borrowers with risky credit can be profitable without engaging in any predatory practices. However, studies by Freddie Mac and Standard & Poor's indicate that 63% of subprime borrowers would have qualified for conventional "A" or "A-" quality loans.
Mortgage Brokers: The Wild, Wild West of Capitalism
Mortgage brokers originate over 50% of subprime loans. Some make money in the same way that prime-rate brokers do: they charge the customer a fee for finding a loan. Most make their money from what is known as a "yield-spread premium," a kick-back from the lender in exchange for placing the borrower into a higher-interest loan than what she would normally qualify for. The higher the fees and interest rates a mortgage broker packs into a loan, the greater their compensation.
Predatory lenders often aggressively market to moderate-income and minority communities, through mail, phone, TV, and even door-to-door sales. Their advertisements promise lower monthly payments as a way out of debt. What they don't tell potential borrowers is that they will be paying more and longer. Worse yet, they will be entering a system that promotes a cycle of debt that has been compared to sharecropping, an economic system that is unequal and unfair.
Mortgage brokers often claim they have no responsibility to find borrowers a good loan. They operate on the unregulated fringes of the financial world, in an environment that has been called "the wild, wild west of capitalism." In many states, brokers need only register with the state without taking a licensing exam or any proof of training. Cosmetologists have higher licensing standards than do mortgage brokers in North Carolina. A mortgage broker that violates lending laws can simply close shop and open under a different name.
The mortgage broker who took advantage of Green's trust in him — and her fear that she wouldn't be able to get a loan from a bank — got a $3,500 fee from the mortgage company, which was taken out of Green's home equity. Green received a loan charging 10% interest, packed with inflated fees, including a loan origination fee of $7,500, 10% of the cost of the loan. Over 30 years, Green will pay $40,000 more in interest than she would have if she had gotten a loan at 8%.
Credit Life Insurance Companies
The mortgage broker also tried to sell Green credit life insurance, another common financial service that is generally only sold on subprime loans. If Green should die, the credit life insurance policy would pay off some of the principal left on the loan. Green decided not to buy the insurance because it was too expensive, but the mortgage broker slipped the credit insurance papers into the stack of closing documents and Green signed anyway.
For the credit insurance she did not want, Green paid $3,000 financed over the 30 years of the loan. This means that Green will be paying for 30 years on a life insurance product that is only good for five. She will end up paying $10,000 for this life insurance over 30 years.
Financial service companies often offer credit insurance that is financed over time to lower the monthly payments on the premium. This increases the cost of the policy, adding on high interest rates and financing fees to the premium. Also, the financing usually takes equity from the home to pay the insurance premium.
Lenders do not offer a range of competitive insurance products to choose from because they often own or affiliate with a credit insurance company whose product they offer. This insurance is more expensive than other types of insurance, while providing lower benefits. And borrowers often don't realize they bought the insurance, or how much it will cost them.
The Secondary Market: What is the Responsibility of Investors?
Now Green is trapped into a high-rate loan because the penalties charged if she prepays the loan using a cheaper loan are so large she cannot afford to do it. Lenders typically add such penalties to subprime loans to keep borrowers from refinancing their loans. Without prepayment penalties, subprime loans are more difficult to sell on the secondary market.
Financial institutions raise more cash to make more loans by selling the loans they already made to the secondary market. Secondary market companies then "bundle" these loans together and sell them to insurance companies, pension plans, mutual funds, and other investors much as prime mortgages are bundled and resold by Freddie Mac, an entity created by the federal government for this purpose.
Green's loan may be sold on the secondary market. Because her loan has a higher rate of return than a prime-rate loan, the lender will be able to charge more for it and make more money. The law forbidding discrimination in the making of loans also applies to companies that buy discriminatory loans on the secondary market.
The Bottom Line: What Happens to the Borrower
Before this loan, Green had built up $23,000 of equity in her home. After the loan, she had less than $2,000 left. More than half of her home equity was lost to fees.
Green will also end up paying more over the long term. Her monthly mortgage payments jumped from $500 a month to $740 a month. Her increased debt service and loss of wealth means that she will be even more vulnerable to economic shocks in the future, and more likely to lose her home through foreclosure.
Those who profited from Green's loss of wealth are the loan broker ($3,500), the lender ($13,900), the credit insurance company ($3,000), and the secondary market, which will make an extra $40,000 on Green's loan.
Why is Predatory Lending a CRA Issue?
The Community Reinvestment Act (CRA) of 1976 allows community groups to hold banks accountable for their lending to minority and low wealth neighborhoods. CRA-regulated banks are subject to a high level of federal regulatory oversight and accountability for their lending practices.
Some banks covered by CRA own subsidiaries that target the subprime market. For example, Bank of America is the largest subprime lender in the country. Wells Fargo owns three subprime lenders: Norwest, Fidelity Financial and Community Credit Co. Some own credit insurance companies. Yet federal regulators do not investigate whether these subsidiaries comply with consumer laws. Independent finance companies that are not banks do not have regular consumer compliance reviews. Thus a two-tier system has evolved, consisting of regulated and unregulated lending.
Why is Predatory Lending a Fair Housing Issue?
Predatory lenders who discriminate get some scrutiny under the Fair Housing Act of 1968. The law requires equal treatment in terms and conditions of housing opportunities and credit regardless of race, religion, color, national origin, family status, or disability. This applies to loan originators as well as the secondary market.
The Equal Credit Opportunity Act of 1972 requires equal treatment in loan terms and availability of credit for all of these categories, as well as age, sex, and marital status. Lenders would be in violation of these acts if they: target African American, Hispanic or elderly households to buy higher priced and unequal loan products; treat loans of protected classes differently than those of comparably credit-worthy whites; or have policies and practices that have a disproportionate effect on the protected classes.
Examples of fair lending violations include giving a black borrower a higher-cost loan than a white borrower with a comparable credit rating, or buying such a loan on the secondary market. Systematic discrimination that creates a separate and unequal credit system that traps borrowers into higher cost loans is also a fair lending violation. But other victims of predatory lending are not protected under law in most states.
Visions for the Future
Ensuring that what happened to Green does not happen to others will require a combination of legislation, litigation, and education. Consumers need to know they can negotiate interest rates and not just take what is offered. They also need to know the warning signs of a predatory loan. In North Carolina, advocates are conducting an education campaign using television commercials, church visits, and flyers distributed through cooperative extensions to spread the word. But financial institutions also need to be held accountable for predatory practices. To prevent predatory lending we must:
- Strengthen consumer protection lending laws at the national level. In July 1999, North Carolina passed an antipredatory lending law that prohibits some predatory lending practices, but still allows for risk-based pricing. It discourages loans charging interest 5 percentage points above the prime lending rate; bans up front financing of credit life insurance; caps fees at 4% of the loan amount; limits refinancing; and requires credit counseling for subprime borrowers. This law should be used as a national model.
- Require that mortgage brokers be licensed. Mortgage brokers are responsible for the creation of a huge percentage of all home mortgage loans but have virtually no professional legal standards for operation.
- Require that government regulators evaluate credit-scoring systems and standardized pricing guidelines. Credit scoring does not ensure fair pricing based on risk unless regulators oversee the pricing policies and practices of financing institutions.
- Hold subprime lenders and the secondary market accountable. The government must start evaluating whether subprime lenders and the secondary market are complying with consumer and fair lending laws.