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Predatory Lending and the Property Investor

Everyone knows property investment can be a high-risk business. However, some investors may not be aware of the risks involved in the initial process of obtaining a loan. In an attempt to maximize the bottom line, and driven by capitalization (CAP) rates, return on investments (ROIs), and net operating incomes, it is understandable that some investors may overlook some seemingly routine details of financing their property. Whether you're borrowing from a bank or a private lender to buy or flip, it's crucial to look closely at your loan. Often the main objective is to turn a property over as quickly as possible, and some investors may pursue higher-risk financing in order to achieve this goal. However, they run the risk of becoming prey to predatory lenders with high-cost loans containing demanding terms and conditions. Rehab loans, or "hard money" loans are often financed through private lenders who are not subject to many federal lending laws which creates even more opportunity for predatory practices.

From a cash-on-cash return basis, leveraging gives an investor a huge advantage; it increases the return, as less cash is invested initially. Some investors subscribe to the theory that positive leveraging occurs when the CAP rate is higher than the interest rate of the loan. This may be so when using fixed prime market financing. But if the loan has features that allow it to negatively amortize, the benefit of investment may drop drastically or even become unprofitable.

From a mortgage lender's perspective, an investor in real estate property can be an easy sell. The investor is most likely a risk-taker by nature, and often has little time to make decisions relating to sudden investment opportunities that arise. But the investor, just as the individual consumer, should be aware of what constitutes predatory practices in mortgage lending, as it may have a deleterious effect on the bottom line.

Defining Predatory Lending?
There is no clear consensus in the industry with respect to defining the term "predatory lending" What has emerged are opinions from authors, existing laws, and proposed legislation that are as numerous and varied as the laws and opinions themselves. As a practical matter, there are some generally accepted characteristics of predatory lending practices.

For consumers, predatory lending exists mostly in the subprime second mortgage market. For investors, where the practice hasn't been as thoroughly studied, it can appear anywhere inside of investment financing, in addition to blanket or other financing that collateralizes the primary residence. Essentially, predatory lending has been described as the following:

• High cost with respect to interest rate and points
• Excessive fees
• Financing single-premium insurance
• Prepayment penalties; balloon payments, persuasion of consumers to mortgage beyond their financial capability
• Repeated refinancing that does not benefit the borrower
• High interest loans given to credit impaired borrowers often accompanied by deceptive or unethical practices
• The addition of high hidden fees
• Overvaluation of property
• Abuse of credit terms

• Knowingly lending money to people who otherwise may not qualify by overstating, or manufacturing income that doesn't exist.

While many of the above items describe some of the generally accepted characteristics of predatory lending, identifying and quantifying the practice is not as simple as it seems. Generally, outside of apparent fraud, the instance of only one of these factors may not mean that the abuse rises to the level of being considered predatory by today's legal standards, but a combination of characteristics and practices, when combined, will more often tell the story. A mortgage lender can be involved in predatory practices even when specific loan features, examined individually, may not appear to contain predatory features.

Predatory lending practices include:

• Unfair targeting
• Reverse redlining
• Questionable relationships among the parties involved in the transaction
• Failure to properly disclose; the use of high pressure tactics
• The use of other undue duress such as deterring applicant from seeking outside representation
• Breach of duty
• Routinely charging exorbitant fees and high interest rates
• Adding un-needed credit and life insurance to monthly mortgage payments, promoting loans that negatively amortize, and regularly providing loans with prepayment penalties and balloon payments.
  

Other practices such as loan flipping, contractor fraud, and false appraisals have also come under scrutiny by the U.S. Department of Housing and Urban Development (HUD) in its nationwide campaign against predatory lending. Patterns of abuse are not exclusive to the mortgage industry. Abuses can also be found among related industries such as unscrupulous contractors, appraisers, and title companies.

What to Look For
One of the complicating factors in identifying the existence of predatory features in a real estate-related transaction is that there is no cut and dry formula to make the judgment. On the contrary, it is generally a grouping of factors that when combined, lead to a conclusion that a transaction may rise to the level of being considered predatory. While there is no clear consensus on defining a predatory loan or practices in connection with mortgage or real estate-related transactions, most would agree that it involves the giving of high interest loans to credit-impaired borrowers which is often accompanied by deceptive or unethical practices. The following reflects what most consider the generally accepted characteristics:

Fraud

• Falsification of information on the loan application, such as income, debts, or assets
• Knowingly pressuring a person to co-sign who has no real connection to or intention to be obligated to the loan
• Forging signatures
• Use of duress, high-pressure sales tactics, and deterring the obtaining of outside representation
  
  

High cost with respect to annual interest rate and points

• HOEPA defines a high cost loan as one that exceeds 8 percent of the Treasury note. Some states have limits that are more restrictive (check with your locale).

• Points are a cost of credit to the borrower expressed in terms of a percentage (1 percent) of the mortgage loan.
  
  

Excessive Fees

• These fees include closing costs such as high broker fees for services of a nominal value, inflated conveyancing and recording fees, and excessively high appraisal costs. In some cases, there is a bundling of fees that results in separate charges for duplicate services. (While fees and costs associated in real estate-related transactions may vary regionally, a good rule of thumb is that the fees, when combined, should not exceed 5 percent of the total loan amount).
  
  

Negative Amortization

• This term is used when the balance of the loan increases rather than decreases over time. Because the payment either contains no amount or a marginal payment toward the principal, interest compounds monthly resulting effectively in a much higher cost to the borrower.

Balloon Payment

• A note that contains a balloon clause requires that while the loan is amortized over a longer period (example: 30 years), an acceleration of the balance is due at a much earlier point. The monthly payment at the beginning of this loan is usually small, however, the entire balance will be required due and payable at the acceleration date of the loan.

Mandatory Arbitration Clause

• Takes away the borrower's right to litigate except through arbitration.
  

Requiring the financing of single-premium insurance

• Insurance such as credit, life, and disability insurance required as a pre-paid item at closing and escrowed in the mortgage payment.

Prepayment penalty

• Penalty applied if the loan is paid off prior to the scheduled term
  

Overvaluation of property

Abuse of credit terms

• Persuasion of borrower to mortgage beyond their financial capability, knowingly lending money to people who otherwise may not qualify by overstating, or manufacturing income that doesn't exist
  
  

The Educated Investor Can Force a Market Change
The long-term solution to reducing the proliferation of predatory lending practices is through educating borrowers. This theory assumes that a correction is possible through the force of informed and empowered consumers driving their needs into the marketplace, thereby creating greater competition within the mortgage market. Using this theory, the assumption is that competition would lead to the development and sale of socially responsible mortgage products. Consumers are a critical factor in maintaining balance and structure as their constantly changing needs influence the provision of goods and services. Educated consumers can influence the marketplace, thereby initiating a shift that can result in cost benefits to all. That includes investors of real estate.

The Perception Dilemma
Unlike an individual consumer, a property investor is viewed, in the industry, as a businessman. The same protections and sympathy from the courts is not as readily available to the investor. Because the investor is in a business of risk, it is often perceived that the business owner is more sophisticated with respect to business matters and more keenly aware of the consequences of his actions than a typical consumer. Traditional contract principles assume that both persons involved in a contract have equal bargaining power. The average consumer does not have the benefit of huge law firms who draft these contracts (notes and mortgages) for major banks and mortgage companies. It is clearly more difficult to argue this point as it relates to a "business" This is the reason an investor must be extra careful when selecting instruments to finance his acquisitions.

Predatory Lending Goes Both Ways
Although the term predatory lender usually pertains to mortgage brokers, in some real estate transactions like lease-options you may end up being the bank. And in that situation, you'll want to make sure you avoid the following practices:

• Making loans on the basis of an overvaluation of the asset
• Accepting fees not disclosed on the HUD1
• Orally agreeing to terms that contradict the written agreement
• Undisclosed loans, gifts, and other things of value
• Yield spread premiums to mortgage brokers
• Repeated financing that does not benefit the borrower

Otherwise known as loan flipping, the lender encourages the borrower to constantly refinance the loan, sometimes at a higher rate or insignificant lower rate or for the payment of unsecured debts and other loans when financing them at an extended term does not benefit the borrower.

• Questionable relationships among parties involved in the transaction
• Bait and Switch:
• Either promising one set of circumstances, yet delivering another, or changing the terms at closing

• Participating in discriminatory practices:
• Targeting or steering high-cost loans specifically to the unsophisticated, the elderly; minorities, or where the giving of high-cost loans results in a disparate impact in a single community or region