Beware of Abusive Home Loan Lending Practices

By Dawn Handschuh, Personal Finance Writer Archive

If you're shopping for a loan that's backed by the equity in your home, be wary of lenders who offer loans based on your home's equity, not your ability to repay.

Abusive lending practices have received much attention of late due to the surge of foreclosures that disproportionately occurred in the sub-prime mortgage market. Sub-prime adjustable-rate mortgages accounted for just 6.8% of all mortgages in the third quarter of 2007 but 43% of all foreclosures, according to the Mortgage Bankers Association.

Ginna Green, a spokesperson for the Center for Responsible Lending, said the sub-prime market "tends to target people with low to moderate incomes, women and minorities, groups that historically haven't had access to mainstream financial institutions and lending."

The sub-prime mortgage market is commonly said to make lending available at a price higher than the prime rate to those with bad credit. The greater risk of default by borrowers with a poor credit history is said to justify the higher costs of sub-prime loans.

For many years, homeownership was simply out of reach for this segment of the population, Green said. The "redlining" practices of the 1960s, where banks didn't invest in certain neighborhoods based on racial lines, has given way to offering risky products, she added. Just five years ago, in 2003, sub-prime mortgages represented only 8% of all mortgage originations; by 2006, they accounted for 28% of all mortgages.

Statistics compiled by the Center for Responsible Lending reveal that minorities hold a disproportionate share of sub-prime mortgages — African-American (52%) and Latino families (41%) were much more likely to hold sub-prime loans compared to white non-Hispanics (22%).

According to Green, at least 50% of sub-prime borrowers could have qualified for a prime loan but were steered into higher cost loans. Her view was confirmed by a 2007 Wall Street Journal study showing that in 2005, the peak of the sub-prime boom, borrowers with good credit scores got 55% of all sub-prime mortgages.¹

"These are bad products, not meant for mass consumption, and if we were talking about a faulty toaster or bicycle, they wouldn't be on the market," Green said.

The Federal Trade Commission warns against these deceptive practices:

Equity stripping
If you're cash-poor but house-rich, unscrupulous lenders may try to "strip the equity" from your home. They encourage you to lie about your income on a loan application, even while your gut says you can't afford the payments. If you proceed with the loan and then default, the lender forecloses.

Loan flipping
You need extra money, so you're all ears when a lender talks you into refinancing your mortgage. A few months later, he dangles an even bigger loan before you, and you take the bait; he refinances again and loans you more money. The lender profits by "flipping" loans because he's charging you points, fees, and possibly a prepayment penalty and higher rate with each refinance.

Plus, you're paying interest on those refinancing charges that were rolled into new loans. Your total debt may dwarf the extra cash you got. Flipping can quickly drain equity from homes that were once owned free and clear.

Home improvement loans
A contractor offers you a home renovation. You're interested but hesitant about the cost. Through his "connections," you get financing, but after he starts work, he rushes you to sign papers you haven't read. Afterwards, it dawns on you that you got a high-interest home equity loan with excessive fees. Adding insult to injury, his workmanship is shoddy, and he stops returning your calls.

Mystery credit insurance
It's closing day, and you're flying high until you spot charges for "credit insurance." The lender downplays it and pooh-poohs your concern. You protest anyway. He says redrafting the loan would delay closing, maybe even jeopardize it. You cave in and get stuck paying unnecessary expenses.

Prepayment penalties
Good-credit borrowers rarely face prepayment penalties. According to a 2007 report by the Center for Responsible Lending, just 2% of prime mortgages contain prepayment penalties, while 70% of sub-prime mortgages do. Yet it's sub-prime borrowers who most urgently need to refinance as soon as their credit improves. If the penalty lasts three years or more, or costs more than six months' interest, take your business elsewhere.

Footnote

¹ "Subprime Debacle Traps Even Very Credit-Worthy," Wall Street Journal, December 3, 2007