Wednesday, November 12, 2014

What is Predatory Lending?

Predatory Lending is one of those terms like "assault rifle" which no one can agree about. 

What is Predatory Lending?   This Wikipedia Link explains some definitions of the term.   Note, however, the definitions are about as succinct as explanations of what exactly is the Holy Ghost.   You get a lot of hemming and hawing, and often contradictory explanations.   But no one seems to agree on any one, simple, concise definition.

From my perspective, Predatory Lending can best be defined as "Lending" - Period.

Why do I say this?   Well, let's take one example from the Wikipedia page:
Failure to present the loan price as negotiable.  Many lenders will negotiate the price structure of the loan with borrowers. 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 unsophisticated borrowers, are not aware of their ability to negotiate and might even be under the mistaken impression that the lender is placing the borrower's interests above its own. Thus, many borrowers do not take advantage of their ability to negotiate.
 When was the last time you went to a bank and negotiated a loan rate?  Probably never (I did it, just once).    Just like you don't go to a gas station and negotiate the price of gas.   They post the rates and you can take-it-or-leave it.  So this definition is pretty useless - as it encompasses nearly all loans.

Or take this definition:
Unjustified risk-based pricing. This 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 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, higher prices are necessary to obtain the same yield on the portfolio as a whole. Some consumer groups argue that higher prices paid by more vulnerable consumers cannot always be justified by increased credit risk.
Also useless.  The interest rate you pay on a car loan, for example, is going to be directly tied to your credit score.  And no, this is not up for negotiation, either.  Of course, this illustrates the one primary fallacy of lending - the worse your credit score is (the higher your risk) the higher the interest rate is charged, and hence there is a higher risk you will default.   It is a snake eating its own tail.

And for those with excellent credit, well, the interest rates are much lower, as there is less risk.   The very rich get the best deals, which they really don't need, while the very poor get the worst.   It is flip-flopped.   But it ain't gonna change.

My definition of predatory lending is different than that of Wikipedia, and more succinct:
Predatory lending is the practice of offering a loan to someone on such onerous terms that you know in advance they will never be able to pay it back, that it will ruin them financially, and you will still make money in the deal.
A lot shorter than the Wikipedia page, but still kind of wordy.  And that is the problem with predatory lending - anything that can't be explained in a sound bite can't be understood by most people - so they choose not to understand it.

Predatory lending is a game anyone can play, from the very poor to the very rich.  And yes, the middle-class routinely steps in this pile of steaming dogshit, much to their regret.   Let's look at some examples:

1.  Larry is short of cash one week, so he decides to get a Payday Loan.   Payday loans are an obvious example of predatory lending.   The lender knows that Larry will not be able to pay back his payday loan, and thus have to take out another one, and over time this will snowball into his bankruptcy. 

Larry can't manage his finances or wait a few days for his paycheck, so he borrows on next week's paycheck.   These loans, if amortized over a year, would have a 30% interest rate.  Next week, he is out of money even sooner, as he has to pay back the previous week's loan.   So he takes out another loan, and the process repeats.   Pretty soon, he is borrowing, every payday, on his next payday.   Larry can't see it, but rolled together, these loans have a "stacked" interest rate of 100-300%.   It is inevitable that he will be buried by them.

And eventually, he defaults on the loan.   Of course, the lender has already collected far more, in terms of interest, than the principal of the loan.  He also collects $25 from Larry for check-cashing fees.  He likely has made a 200% return on his investment, in a few short months.   And he will make more in Bankruptcy.

Larry declares bankruptcy and the judge forces Larry to "work out" his debts over the next five years.   Larry makes small payments on the "debt" owed the payday loan place.   And of course, another payday loan place will offer to lend him money.   Why not?  Larry can't declare bankruptcy for another seven years.   They've got him.   And since his credit rating is shot, well, he can't borrow anywhere else.   So much for negotiating your rates!

For Title Pawn loans, the pattern is the same - high interest rate loans that they know will never be paid off.   They milk the borrower for all they can get, and then tow away his car, which they sell to pay off the principle of the loan.   The rate of return for the lender is fantastic.

Predatory lending at its finest!  But predatory lending isn't just for poor folks, the middle-class can play, too!

2.  Fred and Wilma decide to buy an RV.  I have written about this before.  Maybe it is a boat.   Doesn't matter.   It is some "luxury" item with a motor attached to it, that depreciates - like clockwork - 50% every five years.  The lender offers to "get them into" the RV or boat by offering a 10 or even 20 year loan at what appear to be attractive interest rates (7% or more).   And of course, the boat or RV depreciates faster than the loan balance, so Fred and Wilma are "upside down" on the boat for most of the term of the loan.

Fred and Wilma really only wanted the boat or RV for a few years.   After five years, they are tired of camping or boating and want to sell.   But they can't.   They are locked-in by the loan.   The deficit in the loan balance is in the tens of thousands of dollars.   In order to pay off the loan, they would have to come up with this amount (which they don't have, as they are salary slaves).   They have enough assets (house, cars, etc.) that declaring bankruptcy doesn't make sense, either.  Even if they could declare bankruptcy, the debt might be "worked out" in bankruptcy court - so the lender would get most if not all of their money back.   So the boat or RV sits in the back yard, while they painfully make payments for another decade.   The lender makes a nice return on its investment, with little risk of default.

The middle class regularly steps in this pile of dogshit.   No one at the loan company explains to them how this could happen to them - and how it will predictably happen to them.

But hey, even "smart" wealthy people can play this game!

3.  I wrote before about serial refinancing.   I met a lady on a cruise ship at a law conference, dressed in expensive clothes.  She and her husband were both lawyers with a big firm in Atlanta, and had a combined income in the hundreds of thousands of dollars.   She confided to me, giggling, that they were "serial refinancers" - refinancing their mini-mansion in Buckhead no less than five times now.

Despite their staggering income, they could not save a dime.   They spent it all on designer clothes, smart phones, and leased cars - for themselves and their children.   They had to live the lifestyle to which they felt they were entitled.   So they ran up credit card debt and when it all became too much to bear, they would take equity out of their home to pay it off.   Well, "take equity out" was what the lender called it.   Others call it borrowing yet more money.
And with the junk fees and closing costs, each time they refinanced, they added thousands to the balance on their loan (in addition to the "cash out") and decreased their net worth accordingly.   While their lifestyle was rich, their bank account was not.  And so long as they could make these huge salaries, they could keep this juggling act going.

But of course, the lawyering business ain't what it used to be.  One of them loses their job, and well, it's all over pretty quickly.

Well, actually not quickly.   You see, they are stubborn - so instead of realizing they are in over their heads, they cash in their 401(k) to make mortgage payments, thinking that "things will turn around soon".   Now, these are smart people who went to college, law school, and aced the bar exam.  They work for a top-notch firm, too!  So they cash in their life's savings to make interest payments to a bank, and within a few years, they are really broke (not that they had a lot of savings to begin with).

* * * 

Of course, all three of these scenarios have one thing in common:  People willingly signed up for these loans. Larry really didn't "need" a payday loan, so much as he wanted a six-pack of beer, or perhaps some crack.   Fred and Wilma didn't "need" an RV or a boat.   And my friend from Atlanta didn't need all the toys and luxury in her life, so much as she felt entitled to it.  You can leave your pen at home and decide not to sign such loan documents.

You'd be surprised.  So many things in your life which you think are needs, are really wants.   You can borrow less or borrow not at all.   You can decide to live within your income.   It is possible to do.

The alternative - perpetual debt - isn't so rosy.   For every dollar you borrow, you have to pay back a dollar-ten, at least.   It goes without saying that you never come out ahead by borrowing money.

All lending is thus predatory lending.