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Avoiding Mortgage Predators

Avoiding Mortgage Predators

August 20, 2001

�I read a lot about predatory lending.  How do I avoid becoming a victim?�   

To educate myself on what makes a victim, I recently studied 51 case histories of households victimized by mortgage lenders.  The histories were provided by ACORN, which has been in the forefront of the struggle against predators.  (If you have a case history to add, or an interest in joining their effort, they can be reached through www.acorn.org.) 

While every case is different, victims share certain features that make them vulnerable to predators.  This column and two others to follow will describe the most important features of victims.  If you see yourself in any of these descriptions�you are now forewarned.

Passivity: Perhaps the most pervasive characteristic of victims by far is that they are passive.  They don�t select a loan provider, the loan provider selects them.  In more than half the cases compiled by ACORN, the victims were solicited by the lenders.  In most of the remaining cases, the victims approached a lender they knew from prior experience, either their own or someone they knew.

Predators in the jungle select prey carefully, and so do predators in the home loan market.  Hardly a day goes by when someone does not try to sell me a list of potential borrowers.  [Because I write about mortgages, I have been misclassified as a lender/broker in many databases.]  Here is a recent example:

�[Name of company] is a leader in providing specialty home loan leads, such as our sub-prime file of home owners where you can select by credit score, amount of revolving credit card debt, or equity in property.�

A homeowner with lots of credit card debt, decent credit and substantial equity in a home is a prime lead.  Lenders who pitch debt consolidation will pay a good price for it. 

Most predators solicit their clients.  If you passively go with a loan provider who solicits you, the risk of getting a predator is high.  Since most loan providers are not predators, the risk of getting one is much lower if you throw a dart at the loan providers listed in the yellow pages.  Of course, getting a referral from someone who understands the market is even better.

Borrowers who allow themselves to be selected by loan providers, stay selected.  Passive borrowers don�t shop alternatives.  They also don�t ask as many questions as they should, which is one of the reasons they usually end up confused about the transaction.

Passivity can be overcome.  Resolve to select the lender rather than have the lender select you.  Selecting an Upfront Mortgage Broker from among those listed on my site, or a loan provider recommended by a HUD-approved counselor, virtually eliminates the risk of getting a predator.  Approved counselors are listed at http://www.hud.gov/offices/hsg/sfh/hcc/hccprof14.cfm.

Confusion:  Almost all of the case histories, which were provided by ACORN, the national community group, involved confusion by the borrower about one or another feature of the transaction.  In some cases, borrowers were under the impression that they were getting unsecured loans rather than mortgages.  In many cases, they purchased credit life insurance under the impression that it was required.  Often, they thought that they were paying a lower interest rate than was in fact the case.  The total amount of fees packed into the loan balance usually surprised them.  A large number did not know that their contract included a prepayment penalty until years later when they went to prepay.

Why so much confusion?  Victims often don�t read documents, or if they do read they are afraid to ask questions about what they don�t understand.  The �Plain English� movement has not impacted mortgage documents, although there isn�t a segment of the economy that needs it more. 

Not reading is not a major problem if the loan provider is honest and competent.  Predators, however, thrive on confusion, which provides a smoke screen for their shenanigans.  To a predator, a reading-challenged borrower is an invitation to take advantage in every possible way.  And mortgages provide lots of ways.

Confusion and passivity go hand in hand, and must be overcome together.  Remember two things: 1.  Mortgages are so complicated even professors get confused; 2.  It is the loan provider�s responsibility to eliminate your confusion.  If he doesn�t do it, walk out the door.   

Indebted:  Victims are often heavily in debt, and therefore vulnerable to the siren call of debt consolidation.  Debt consolidation was the primary motivation in about 2/3 of the ACORN cases. 

The argument is compelling.  Make one lower payment, and enjoy tax benefits besides.  While these advantages can be real, they tend to disappear in dealing with a predator.  Sometimes the payment is higher rather than lower because of the stiff interest rate.  Even if the payment is lower, the borrower�s equity is depleted by the inclusion of large upfront fees in the loan.  Consolidate debts with a predator and you end up worse off than you were before. 

Consumers who have accumulated too much short-term debt have an option other than debt consolidation.  They can instead work out a debt management plan with a credit counselor.  In exchange for agreeing to take on no new debt and to pay off the old debt within a prescribed period, the counselor can get the creditors to agree to a reduction in interest rates.  The consumer makes one payment to the agency, which in turn pays the creditors.  This avoids one of the perils of debt consolidation, which is that it may encourage a new credit binge.

If the indebted consumer opts for debt consolidation, it can be done by taking a second mortgage for the amount of the debt, or by a cash-out refinancing of the first mortgage.  In the refinancing, the new loan balance is large enough to cover the debt as well as the old balance. 

Whether a second mortgage or a cash-out refi is less costly for the consumer is a tricky question that depends on a number of factors.  One of the calculators on my web site was designed to answer this question.  But you won�t find this (or any other) calculator being used by a predator.  Predators consolidate in the way that is most costly to the consumer, because that generates the most revenue for the predator.

Consumers with excessive short-term debt who are too passive or confused to use a calculator or shop alternatives will do better seeing a credit counselor rather than a loan provider.  While not all counselors are great, the loss is small if you get a bad one.  If you go to a loan provider who turns out to be a predator, the loss can be catastrophic.

Cash-Dazzled:  Many victims are cash-dazzled -- the prospect of pocketing a significant sum of money causes a complete lapse of judgment.  They ignore where the money is coming from and what it is costing them.

Predators love cash-dazzled victims because they are prime candidates for cash-out refinancing � refinancing into loans that are larger than the outstanding balance of the old loans.  Frequently, the new loan has a higher interest rate than the old one, and the refinancing fees are added to the loan balance.  Some borrowers will refinance again and again, a practice known as �flipping�, until they have used up all their equity. 

There are many legitimate cash-out refinance transactions.  They become predatory when the cash-dazzled victim agrees to terms that are far more costly than the borrower could have obtained by shopping alternative sources.  The alternatives include home equity loans. 

In many cases, borrowers who need cash do much better with a home equity loan than with a cash-out refinance.  Even when the rate on the home equity loan is high, that rate is paid only on the additional cash required.  On a cash-out refi, the new higher rate is paid on the old loan balance as well as the additional cash.

The worst rip-off is cash-out refinancing of zero interest loans, a problem that has plagued the Habitat for Humanity program.  The Coalition for Responsible Lending estimates that ten percent of all Habitat borrowers between 1987 and 1993 subsequently refinanced their zero interest loans into loans carrying rates of 10-16%.  Borrowers who did this were paying interest costs of 60% and up for the cash in their pockets.  Cash-dazzled victims don�t see it.

In the case histories of borrowers victimized by predators, a surprisingly large number had had a satisfactory credit experience with a reputable lender in prior years.  In some cases, they had completely paid off their mortgages.  Then the prospect of cash-in-hand lured them into the hands of a predator.

Payment Myopic:  Victims often base decisions solely on the affordability of monthly payments; they are payment myopic.  They don�t consider interest costs or how the decisions will affect the equity in their homes. 

Predators love payment myopic victims because, like cash-dazzled victims, they offer little resistance to upfront charges that are included in the loan amount.  An upfront fee of $2,500 reduces the borrower�s equity in his home by the same amount, but that doesn�t matter to the payment myopic borrower. What matters is that at 10% and 30 years, the $2,500 converts into only $22 a month. 

Here is the kind of deal that payment myopic/cash dazzled borrowers find irresistible. The borrower has paid down his 8% loan to $100,000 and has only 12 years to go.  He is offered a 30-year loan for $110,000 at 9%.  The monthly payment would fall from $1082 to $885, and he puts $10,000 in his pocket tax free.  What a deal! 

Of course, 5 years down the road, he would have owed only $69,449 had he stayed with his original mortgage.  With the new mortgage he will owe $105,468 -- even more if there are upfront fees included in the new loan, which is almost always the case.  Payment-myopic borrowers don�t look down the road.

Just because you are cash-dazzled or payment myopic does not mean you must be a victim.  You can avoid victimization if you steer clear of temptation.  Alcoholics who are on the wagon have a trusted advisor who they call when they feel their control weakening.  Impulsive borrowers can do the same.  If all else fails, you can email me, but expect a stern lecture.

Copyright Jack Guttentag 2002



Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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