Saving Homeowners From Unscrupulous Lendersand Themselves

“Don’t Borrow Trouble.” That’s the slogan of the City of Boston’s new program to educate consumers about loan scams and unethical lending practices that could cost them their homes. Given that more than 1,000 home-equity loans and refinanced mortgages were written in Boston’s lower-income neighborhoods last year alone, it comes not a moment too soon.

This program is an acknowledgment that there is a problem keeping people in their homes once they’ve purchased them. Equally significant, mortgage-industry trade groups are backing the program and picking up half its cost, thereby breaking rank with their less ethical brethren in a way they’ve never done before. “Banks used to be in denial, if not outright defensive, about these problems,” said Thomas J. Hollister, president of Citizens Bank of Massachusetts and chair of the Massachusetts Community Banking Council. “Working with community activists, we’d like to assure that everyone has access to fair credit.”

People working in anti-terrorism call this process “target hardening.” That is, it makes potential targets harder to victimize. And that’s what the sponsors of “Don’t Borrow Trouble” hope to do. But in the case of scam loans and unethical lending practices, an educational campaign by itself may make no more than a dent in the problem.

For all too many borrowers in still-depressed urban neighborhoods–not only in Boston but in Brockton, Lawrence, Holyoke, and other cities–obtaining a home-equity loan or refinancing a mortgage is often just one more desperate move by an already financially desperate person. And desperation is not a frame of mind conducive to comparison shopping, let alone “Just-Say-No”-style financial self-restraint.

Despite our currently buoyant economy, working-class people in Massachusetts are under tremendous financial pressure. Since 1979, people who lack a high-school degree have experienced a 38-percent decline in real income while prices of existing homes have risen 233 percent. Many people, even homeowners, now spend more than half their income on housing. Many live from paycheck to paycheck. For these families, disaster is always right around the corner. One-third of working-class families suffer some income interruption each year. Many have inadequate health insurance or none at all. Their houses are often old and in need of repair. Tenants can withhold rent if something breaks, cutting off another source of cash.

But if income is limited and prone to interruption, credit is free-flowing. According to the Federal Reserve Bank’s 1998 Survey of Consumer Finances, 32 percent of families with income less than $10,000 shell out more than 40 percent of their income in debt payments, as do 20 percent of households with income between $10,000 and $25,000. When credit limits are reached, or monthly minimum payments get too hard to meet, they may turn to the untapped equity in their house, which is growing as a result of huge increases in real estate prices in the past several years. Last year in Dorchester, for example, median house prices rose $44,000. Drowning in debt, many people will sign anything they believe will lower their payments and get rid of the bill collectors.

Too-easy money is an ironic, and unintended, consequence of righteous crusades against inadequate credit. Community activists have protested redlining–the withholding of credit from inner-city, minority, and lower-income neighborhoods–for 30 years. The Community Reinvestment Act has prohibited this practice since 1977. And advocates continue to pressure banks to increase lending in communities they once shunned.

While activists pushed to make more credit available, a growing difference in the quality of credit made the loans offered in poor neighborhoods increasingly risky for borrower and lender alike–and costly. A recent study in Chicago by the Woodstock Institute, a 26-year-old nonprofit research organization, showed that in white-majority census tracts, home loans are provided mostly by banks, while lending in minority neighborhoods is done mostly by mortgage and finance companies that specialize in higher-risk markets, which they service at a higher cost. This is not always because this high-risk, or subprime, credit is the only credit for which residents qualify. A recent study by Freddie Mac, a secondary mortgage-market company, found that one-third of subprime borrowers could have qualified for a prime loan, and so were paying a rate out of proportion to the risk they represented. Currently, lenders are not required to give borrowers the lowest rate for which they qualify.

The distinction between upright banks & usurious money lenders is blurring.

But the distinction between upright, but cautious, banks and usurious money lenders is blurring. An increasing number of banks have gotten into the business of subprime lending–making higher-rate loans to people with less-than-perfect credit–as interest rates have risen and the volume of refinancing has dropped. American Banker, the banking industry newspaper, reported that, as of last year, 25 percent of banks are in the business of making these riskier loans, either directly or through a subsidiary. That percentage is likely to soar in 2000, as mainstream secondary-market buyers Fannie Mae and Freddie Mac begin purchasing more subprime loans in response to pressure from the US Department of Housing and Urban Development to increase their funding of loans to African-Americans.

Subprime loans are, by themselves, neither predatory nor unfair. What distinguishes predatory lending are practices, not justified by risk, that make it more likely the borrower will lose their home than be able to repay the loan. At a hearing of the US Senate Special Committee on Aging in 1998, consumer advocates and academics, as well as Jodie Bernstein, director of the Bureau of Consumer Protection of the Federal Trade Commission, outlined some of these unfair practices: charging excessive points (1 percent of the loan amount, paid to the lender up front) and origination fees, requiring unnecessary pre-paid credit life insurance, and adding unearned payments to third parties (such as brokers the borrower has never met).

Such fees could turn a $50,000 loan, for instance, into a $65,000 loan. If the borrower gets behind in payments, these lenders may entice, or force, the borrower into refinancing at a higher amount–“flipping” it–thereby adding a whole new round of points and fees, calculated on the entire amount of the loan. Now the $65,000 loan is up to $80,000, even though the borrower got no new money. Before long, the loan exceeds the owner’s equity and the lender forecloses, taking possession of the property.

Cash-starved borrowers may also fall prey to other traps, such as negative amortization, under which monthly payments are less than the full cost of principal and interest, actually increasing the amount owed over time. Steep pre-payment penalties prevent borrowers from repaying the loan even if they find they can get better terms elsewhere. Balloon payments, in which the entire principal comes due in a lump sum, can force refinancing or foreclosure if the borrower is unable to pay off the loan or refinance elsewhere. Stuart Rossman of the National Consumer Law Center says he is most concerned by a new wrinkle: mandatory arbitration agreements. This eliminates not only the possibility of legal action but “virtually every consumer protection in existence,” he says.

Nationally, the foreclosure rate for prime mortgages was less than 1 percent last year, and for subprime mortgages, 4.8 percent. By contrast, the foreclosure rate for 1999 in Roxbury was 10 percent, 15 percent in Mattapan, according to the city’s Department of Neighborhood Development. This is already a big enough number to hurt not only homeowners but entire neighborhoods–and perhaps enough to suggest that predatory lenders have made inroads there.

And that’s with property values going up. During the last economic downturn, in the early ’90s, a massive wave of foreclosures put more than half the houses on some streets in lower-income neighborhoods on the auction block. When the dust settled several years later, no one on those streets knew anyone. What sociologists call the neighborhoods’ “social capital” was completely destroyed.

Since then, state and federal legislation has been passed that proponents hoped would reduce the number of foreclosures due to unscrupulous lending. In Massachusetts, every mortgage banker or broker now has to be licensed and examined every two years for compliance with consumer protection laws. The Federal Home Owners Equity Protection Act, passed in 1994, limits practices like balloon payments and pre-payment penalties for very high-rate mortgages. But gaping loopholes remain. The state law that limited lenders to charging no more than two points was changed in 1994 to a vaguer prohibition of “unconscionable” points–those out of line with industry standards. State Commissioner of Banks Thomas Curry is struggling to define this standard so that it doesn’t have to be argued on a case-by-case basis.

Meet the Author
Last summer, North Carolina passed new legislation to prohibit many predatory lending practices. New York State issued new draft regulations in December for the same purpose. There are no such legislative or regulatory initiatives currently underway here, although Massachusetts regulators are about to begin performing joint examinations of large national lenders with New York.

When a family loses a house, the neighborhood loses a neighbor. If a lot of families lose their houses, the neighborhood loses itself. For the sake of the neighborhoods themselves, foreclosures resulting from too-loose credit and predatory lending practices must be stopped. It will take more than an exhortatory “Don’t Borrow Trouble” campaign to accomplish that.

Ada Focer is a former Massachusetts deputy commissioner of banks. Her current housing research is funded by TIDE, a John and Charlotte Bemis Family Foundation.