What Is a Predatory Loan, and How Can You Avoid One?

Find out what predatory loans are and how to make sure you don’t take one out.Image source: Getty Images.

Many people have to borrow money at some point in their lives to fund big purchases, buy a house, or go to college. Sometimes borrowing money can even help you improve your financial situation. 

But not all loans help borrowers accomplish their goals. Some loans are predatory and can do serious financial damage. Predatory lenders mislead borrowers. They lock people into financing under terms they don’t expect or understand.

A predatory loan can cost you a fortune and ruin your credit in the process. It’s important to understand how predatory loans work and what red flags to look out for. Here are some tips to make sure you don’t accidentally take out this type of loan.

What is a predatory loan?

Any type of loan can be predatory, including a mortgage loan, personal loan, or auto loan. What all predatory loans have in common is that they mislead borrowers. 

Lenders may be dishonest about the costs and fees associated with the loan by hiding details in the fine print. Or they could make loans to people who have no business borrowing -- often in the knowledge that the borrower will default on the loan. 

Predatory lenders target those who are desperate to borrow money or who don’t understand how borrowing works. These loans are often heavily advertised. They could be sold door-to-door or via mail, phone, TV, or online advertising.

Vendors include:

• Dishonest lenders,
• Mortgage brokers,
• Car dealers,
• Real estate brokers,
• Home improvement contractors, or
• Anyone trying to make a quick buck by compromising the borrower's financial security.

What are some examples of predatory loans?

Here are some common examples of predatory loans:

• Loans with surprise fees in the fine print: Lenders may hide the true costs of a loan by obscuring details about the fees. There could be surprise origination fees, application fees, or prepayment penalties. Lenders could also hide the fact that the interest rate is variable and could rise dramatically.
• Loans borrowers are meant to default on: Lenders may approve people who clearly cannot afford the loan payment. This often happens with secured loans. For example, a lender might encourage a borrower with bad credit to make a large down payment and take out a big auto loan for a car that’s not worth much. The down payment alone may come close to covering the cost of the vehicle. The lender will then collect payments until the borrower defaults. When that happens, the lender repossesses the car, leaving the borrower with nothing.
• Bait-and-switch loans: With these loans, lenders advertise a particular kind of loan or interest rate but deliver loan terms that are different than promised. Many borrowers don’t notice the true loan terms until after they commit, or find that monthly costs only go up after payments have begun.
• Loan churning: Borrowers may be encouraged to refinance loans again and again for no reason, paying high fees each time they do so.
• Loans with unnecessary add-ons: Borrowers may be required to buy a bunch of unnecessary services along with their loan, or find they have been unknowingly signed up for those services. For example, a borrower may be forced to take out loan insurance and get stuck paying premiums without understanding what it is or why they need it.
• Balloon loans: Sometimes borrowers are enticed into taking out a loan by promises of low monthly payments... but the lender never explains that there’s a big balloon payment due in a short time. When the balloon payment comes due, the borrower will have to come up with a huge chunk of cash to pay it off. This could be impossible and might force the borrower to take out another loan.
• Loans designed to trap borrowers in debt: Some loans are designed to trap you in a cycle of debt. They have high fees and short repayment periods, meaning people end up having to borrow again to pay them back. Payday loans are a famous example of this. The fees are so high and repayment terms are short, it’s almost inevitable that you’ll get stuck taking out another payday loan.

Any of these types of loan could hurt your credit, cost you a bunch of money paying back an unaffordable debt, and make your financial life harder, both now and later.

How can you avoid a predatory loan?

You don’t ever want to take out a predatory loan. Fortunately, there are some things you can do to avoid falling prey to unscrupulous lenders. Here are some ways to avoid predatory loans:

• Understand the loan terms of any debt you take on: You should understand all fees and costs associated with the loan. Will you owe prepayment penalties if you pay off your loan early? Is the interest rate fixed or variable? What's your payment schedule? When will the debt be paid off in full?
• Be wary of aggressive sales tactics: If someone comes to your door pushing a loan or aggressively presses you to borrow via mail, email, or phone, this is a big red flag. While reputable lenders may send you occasional offers, they won’t bombard you with mail and won’t show up at your house. They let you know of their offers and wait for you to come to them. 
• Watch out for “bad credit” loans: Whenever loans are targeted to more “desperate” borrowers -- people who can’t borrow through conventional means or who need funds quickly -- be very, very cautious. Dishonest scam lenders often target the most vulnerable, knowing they may be in desperate need of a car loan or fast cash to get them through to payday. 
• Research any lender you’re considering: Check the Consumer Financial Protection Bureau to see if the lender has been the subject of complaints and check their Better Business Bureau ratings. Avoid lenders that have a lot of negative comments from current customers and stick to reputable lenders with good ratings.
  
  

Don’t let predatory lenders ruin your finances

Borrowing from a predatory lender is always a bad idea. If you need to borrow money, make sure you research your options carefully and choose a lender that's up front about costs and fees. The potential to ruin your credit score -- or face expensive and unexpected costs -- means predatory loans are never worth taking.