10 Real Estate Finance - Chapter 6: Predatory Lending and Mortgage Fraud

Prepayment Penalties

A lot of the time, these ARMs are described with sets of numbers like "2/28" or "3/27", so if you see those, they might be subprime. These types of loans will also tend to have prepayment penalties. This means that if someone wants to pay this thing off early, they're going to have to pay extra. Seems a little weird, right? The reasoning for this is that lenders want to be able to predict their incoming cash so they can make accurate business predictions for the future.

Property Flipping

A specific type of mortgage fraud that's been (unfortunately) popular is called flipping. To be clear, I'm not talking about the kind of house flipping you see on those HGTV shows. Buying a cheap, distressed house, making truly valuable improvements, and reselling it for a fair price for a profit is not fraud. The type of flipping I want to tell you about is different, and it's mortgage fraud. Let's talk more about this.

Report It!

Hopefully this is something you never run into as an agent. If it is, make sure you report it. And even though it might be a big setback for a client to get this far and need to back out, it's way better to back out than be stuck in a risky situation and potentially being foreclosed upon in the future - which will ruin their financial standing as a future borrower. I'm sure that we've all heard the famous saying, "It's better to walk away than to be stuck in a fraudulent mortgage."

Warning Signs: Unwanted Risk

Is your client being swindled into getting a more risky loan than they'd like? That's a red flag. Your client should know what they are getting and be willing to get a riskier mortgage, if that's what they want. If not, there's definitely something to be suspicious about. If your client who has a risky mortgage mentions anything about not getting the loan they originally wanted, it's time to maybe do some digging into their loan pre-approval and lender. 🕵️

Party Payment Disclosure

It is essential that the lender knows exactly how much money for down payment and closing costs are being paid from the buyer's funds. Anything being paid by any other party in the transaction must be disclosed in the contract and on the closing statement.

New York Banking Law §6-L(11)

And what happens if a loan violates any of the State provisions? The borrower will be able to rescind the loan, without any time limitation. Upon a judicial finding that a high-cost home loan violates any provision of this section, whether such violation is raised as an affirmative claim or as a defense, the loan transaction may be rescinded. Such remedy of rescission shall be available as a defense without time limitation.

Buyer Rebates

Anything during the transaction that causes money to go back to the buyer, either at or after closing, without the knowledge of the lender, is illegal. This is known as a buyer rebate. Sometimes the money comes from the seller, sometimes from the real estate agent or a mortgage loan broker, and sometimes through a third party vendor.

Warning Signs: High or Unpredictable Fees

How are the fees? Do they seem really high or do they change at closing? That's a red flag. Make sure at closing you compare the fee estimate with the final charges from the lender. If there are large differences in the lender's favor, there's an issue. If they are in the client's favor, that's usually okay. Work with your client and use your best judgment to decide what to do. If they feel like they need to cancel the loan, that's a big step, but muuuch better than the consequences of not cancelling a bad loan.

Do the Fees Make Sense?

However, does the loan have above-average or unnecessary fees that seem to be out of the ordinary? Maybe the borrower has great credit, but is getting a less-than-stellar interest rate? Any of these things plus others can be signs of predatory lending.

Warning Signs: Pressure to Act Fast

Is your client being pressured to act fast, to take advantage of the rate before it changes? That's a red flag. This is a huge decision that could affect the rest of their lives. It should take time and deliberation before a client figures out what they want to do. No one, especially a lender, should be pressuring a client to make a decision within a set amount of time. (By the way, in sales, this is called creating a sense of urgency.)

New York Banking Law §6-L(2)(k)

As I just stated, New York is very strict when it comes to lenders issuing loans with no regards to the borrower's ability to repay the loan: No lending without due regard to repayment ability. A lender or mortgage broker shall not make or arrange a high-cost home loan without due regard to repayment ability, based upon consideration of the resident borrower or borrowers' current and expected income, current obligations, employment status, and other financial resources (other than the borrower's equity in the dwelling which secures repayment of the loan), as verified by detailed documentation of all sources of income and corroborated by independent verification.

Understanding is Key

Basically, a lender should not be making an unreasonable amount of money from a borrower. They should be making a fair and decent amount from a borrower who understands that they are getting the best product for their money. Even if the loan isn't exactly 100% in the borrower's best interests, that alone doesn't make it predatory. If the borrower fully knows and understands the parameters and still willingly accepts the loan, that is not predatory. It may, however, still be unwise.

Up in ARMs

Lenders have become creative in the way they structure subprime mortgages. One type of mortgage, which you've learned about already, is the adjustable rate mortgage (ARM). This is generally a 30-year mortgage that charges a low rate for the first two or three years, then resets at a rate based on a current, prevailing benchmark rate like the London Interbank Offered Rate (LIBOR). Often, this reset rate will be higher than the initial rate.

Subprime Can Be Just Fine

Subprime lending can go wrong (and it certainly has in the past). But that doesn't mean that subprime mortgages are inherently bad or predatory. They just have terms that correlate to their increased risk levels for the lender. As long as the borrower is aware of their finances and stays current on their mortgage, a subprime loan doesn't have to be a negative thing. Instead, it could be a helpful way for someone to increase their credit score while also earning equity in an investment. It's only when the lending becomes predatory that subprime loans start to become an issue.

Anti-Predatory Lending Laws

The Home Ownership and Equity Protection Act (HOEPA) was created in 1994 as an amendment to the Truth in Lending Act (TILA). HOEPA's goal was to end abusive and predatory practices by lenders. The Act created a lot of restrictions for what it deemed to be "high-cost loans," or loans with an annual percentage rate exceeding the average rate for similar transactions by more than 6.5%. The Act prohibits all sorts of predatory practices. Note that this is a percentage difference, so we're not talking about the difference between 5% and 11.5% - interest rates for similar transactions will be much more similar than this. (6.5% higher than a 5% would be 5.325%.) If you are interested in learning more, the Consumer Financial Protection Bureau has more information.

Warning Signs: Lying on the Application

did the lender ask your client to lie on the loan application? That's a red flag. A huge, HUGE red flag. 😱 This is straight-up mortgage fraud. Tell your client to run far, far away. If you're sure this was mortgage fraud, you or your client can gather up all the info necessary and report it to the FBI, the Federal Trade Commission, HUD, or if it's a local lender, call the local law enforcement agency.

Higher Rates and Fees

Because of the default risk associated with such borrowers, subprime mortgages have very high interest rates and much higher fees as compared to prime loans. This, combined with the fact that many subprime borrowers don't have the same level of financial knowledge as a prime borrower, means a lot of predatory lending takes place in the subprime market. That's why it's important for potential homeowners to shop around for mortgages, especially if their credit is less than stellar. This way, they can see what interest rates they're being charged by different lenders and can pick one that has the best rates and features, hopefully avoiding predatory lenders.

Remedies for Predatory Violations

Borrowers have options for remedying a predatory loan. The following comes from New York Banking Law §6-L(10), (12), and (12), respectively. Upon a finding by the court of an intentional violation by the lender of this section, or regulation thereunder, the home loan agreement shall be rendered void, and the lender shall have no right to collect, receive or retain any principal, interest, or other charges whatsoever with respect to the loan, and the borrower may recover any payments made under the agreement. A borrower may be granted injunctive, declaratory and such other equitable relief as the court deems appropriate in an action to enforce compliance with this section. The remedies provided in this section are not intended to be the exclusive remedies available to a borrower of a high-cost home loan.

Aggressive Tactics

Consumers can be lured into dealing with predatory lenders by aggressive mail, phone, TV, and even door-to-door sales tactics. Their advertisements promise lower monthly payments as a way out of debt, but don't tell potential borrowers that they will be paying more and longer. They may target minority communities by advertising in a specific language, or target neighborhoods with high numbers of elderly homeowners, or homeowners with little access to credit.

Common Predatory Lending Practices

Equity Stripping:The lender makes a loan based upon the equity in your home, whether or not you can make the payments. If you cannot make payments, you could lose your home through foreclosure. Bait-and-Switch Schemes:The lender may promise one type of loan or interest rate but without good reason, give you a different one. Sometimes a higher (and unaffordable) interest rate doesn't kick in until months after you have begun to pay on your loan. Loan Flipping: A lender refinances your loan with a new long-term, high cost loan. Each time the lender "flips" the existing loan, you must pay points and assorted fees. Packing: You receive a loan that contains charges for services you did not request or need. "Packing" most often involves making the borrower believe that credit insurance must be purchased and financed into the loan in order to qualify. Hidden Balloon Payments: You believe that you have applied for a low rate loan requiring low monthly payments only to learn at closing that it is a short-term loan that you will have to refinance within a few years.

When Subprime is Sublime

For a borrower with a low credit score who wants to purchase a house, a subprime mortgage is often the only way to do it. Sometimes, however, buyers can use the subprime mortgage to their advantage. For instance, assume a borrower uses an ARM to purchase a home in a neighborhood where prices are expected to increase. Paying the lower mortgage payments for two years will improve their credit rating. Then they can sell the house just before the interest rate adjusts, hopefully at a gain because the house increased in value. The borrower can then use this money to buy another house, this time without a subprime mortgage.

A Dangerous Game

For example, if the first buyer purchases the home for $400,000 (which is the actual value) and then resells it at $600,000 with help from a phony appraisal and a straw (phony) buyer, they might each pocket $100,000. No payments are made on the $600,000 loan, and when the lender forecloses, they find the property is only worth $400,000. The lender takes a loss, their costs increase, and we all pay.

Some Red Flags

Here's a list of things you and your client can look for to spot potential mortgage fraud. Mortgage fraud red flags include: Inflated price or appraisal Real estate agent is asked to remove the property from MLS (a violation of MLS rules) or being asked to increase the price in MLS to a higher price to match the sales price False financial statements by the buyer Contract calling for payments at closing for future improvements High fees to the mortgage broker, real estate broker or both No fee for a title policy on the closing statement A title company you have never heard of before Last minute amendments to the contract, increasing the sales price

Mortgage Fraud

Let's begin by talking about mortgage fraud. Unfortunately, real estate fraud is something that's happened a lot in the past and can still happen today. Almost anyone involved in a home buying transaction could be involved in committing fraud: the agents, mortgage broker, appraiser, or title company. The mortgage lenders are usually the victims. Mortgage fraud results in inflated appraisals and property values, as well as bogus documents recorded in public records. Anytime these kinds of losses occur, it damages everyone.

Subprime Lending

Let's begin by talking about subprime mortgages. Subprime mortgages are a type of mortgage that is normally made to borrowers with lower credit ratings. The lender offers a mortgage with a higher interest rate because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. You've probably heard the term subprime used a lot, especially after the 2008 housing crisis. Well, let's talk about what it means exactly and why it has negative connotations.

Warning Signs: Super Low Interest Rates

Let's talk about how you can spot predatory lending practices and stop these bad guys in their tracks. Look out for these warning signs: Is the lender marketing astonishingly low interest rates? Is it below market? That's a red flag. 🚩This might just be a trick to get a client to call them up, only to have them learn that the rate isn't available. Even if the interest rate is low and your client still wants to go with that lender, they will probably try to make up for the difference with some sort of fees somewhere along the line.

Usury Laws

Most states have usury laws, which limit the maximum interest rate a lender can legally charge. In New York, loans made to an individual that are under $250,000 have a maximum annual interest rate of 16%. Exceeding that limit of 16% is considered a civil offense. If the lender charges an interest rate that exceeds 25%, it becomes a criminal offense. If the loan amount is larger than $250,000, there is no civil limit of 16%, but the criminal offense at 25% still applies.

New York Banking Law §6-L(l)(i)

NY law also states that there cannot be lending without giving the borrower a counseling disclosure and a list of counselors. A lender or mortgage broker must deliver, place in the mail, fax or electronically transmit the following notice in at least twelve point type to the borrower at the time of application: "You should consider financial counseling prior to executing loan documents. The enclosed list of counselors is provided by the New York State Department of Financial Services."

NY Anti-Predatory Lending Laws

New York has passed plenty of state-specific laws to prevent predatory lending, many of which outline which loans are considered "high cost." New York legislation has gone further than federal law, and has banned practices such as lending without regard to the borrower's ability to repay the loan. Most of these provisions appear in the New York Banking Laws.

Most Common Rebate

One of the common forms of rebates happens when the contract calls for money to be paid to a certain vendor for future improvements to be done to the property after closing. For example, $20,000 is to be paid to ABC Home Improvements for future improvements. ABC Home Improvements is owned by a friend of the buyer and after closing the friend and the buyer split the $20,000. No improvements are made, no payments are made, and the lender has to foreclose and finds the property worth less than the loan amount.

Home Equity Loans

People that are in a large amount of debt might be tempted to take out a home equity loan to pay it off. Their credit card interest rate might be above 20%, while a home equity loan's could be in the single digits. This could be useful to a borrower if utilized correctly. For example, a borrower would save money if they were able to get a substantially lower interest rate and pay off the credit card. Better to be paying 5, 6, or even 10% in interest than the 20% or more that credit cards can charge. In taking out the loan, the borrower would also be consolidating their debt to one payment. This is known as debt consolidation. But, as you probably remember from a previous chapter, a home equity loan is a loan in which funds are borrowed using the homeowner's equity for collateral. So, if the borrower finds themselves unable to repay the loan, they could lose their home. Borrowers should carefully consider their options before taking out a home equity loan. Home equity loans are not predatory by nature. In fact, it could be the right financial decision for someone. But, as we just said a few screen ago: predators like collateral. Borrowers should examine the terms of a loan very carefully before taking out a home equity loan. A predator might hit the borrower with a large balloon payment at the end, or a variable rate might put the borrower in a worse position than when they started. Debt consolidation through a home equity loan can be a risky move, and borrowers should be made aware of those risks. In addition, borrowers can find debt consolidation loans that don't use home equity as collateral.

Be a Super Agent!

Predatory lending is not as common as it once was. Rather unluckily for you as an agent, you'll still have to keep an eye out for predatory lending to make sure your client isn't being targeted. But also lucky for you, since the housing crisis, it's easier than ever to spot these types of predatory lending strategies and become the hero your clients deserve. Super agent to the rescue!

Predators Like Collateral

Predatory lending typically occurs on loans backed by some kind of collateral, such as a car or house, so that if the borrower defaults on the loan, the lender can repossess the property, sell it or foreclose on it, and make their money back. Lenders might be accused of tricking a borrower into believing that an interest rate is lower than it actually is, or that the borrower's ability to pay is greater than it actually is. The lender, or others as agents of the lender, may even profit from the repossession or foreclosure upon the collateral.

Products Aren't Predatory

Products themselves are not predatory. For example, a loan with a variable interest rate can be a very good financial tool for many borrowers. However, if the borrower is sold a loan with a variable interest rate disguised as a mortgage loan with a fixed interest rate, the borrower is the victim of a bait and switch or predatory lending practice. In short, this type of conduct is nothing more than mortgage fraud practiced against consumers.

Subprime Loans

So, a subprime loan is a loan that has an interest rate greater than the prime rate. If the borrower has less than good credit, this is the option they'll be given by the lender. Their assessment and qualification is based on a few factors, including, in this order: Credit score Size of down payment Number of delinquencies on a borrower's credit report Types of delinquencies Even if there is just one area in which the borrowers are below standard, such as credit score, the lender will be less willing to give them a prime loan, even if their income and assets are to the lender's liking. Even if the borrowers don't meet the qualifications, the lender might still deem them creditworthy enough to lend them the money for a house, so the borrowers could be given pre-approval for a subprime loan.

More on Predatory Lending

The Washington State Department of Financial Institutions explains predatory lending really well, so I'll borrow some of their words here: Lending and mortgage origination practices become "predatory" when the borrower is led into a transaction that is not what they expected. Predatory lending practices may involve lenders, mortgage brokers, real estate brokers, attorneys, and home improvement contractors. Their schemes often target people who have small incomes but substantial equities in their homes.

Predatory Lending

The acts of predatory lending that I'm about to describe are NOT a reflection on all lenders. They have been committed by some lenders (That's why you need to learn about it!), but I mean no offense to lenders in general. The majority of lending professionals play by the rules and care about their customers! Predatory lending includes the unfair, deceptive, or fraudulent practices of some lenders during the loan origination process. While there are no legal definitions in the United States for predatory lending, an audit report on predatory lending from the office of inspector general of the FDIC broadly defines predatory lending as "imposing unfair and abusive loan terms on borrowers."

Interest Rate Caps and Adjustments

The borrower will also have to look out for subprime loans that don't have interest rate caps. This means they can just go up and up and up with no limit, which is going to be hard for anyone to deal with. Once a borrower's payment adjusts out of their introductory rate, they're often unable to afford the new higher rate, and end up defaulting on the mortgage. This is one of the factors that lead to the subprime crisis in 2007. Many people were given subprime loans which they could only afford as long as the market was strong. When the housing market started to go south, millions of these borrowers defaulted, and this touched off the financial crisis.

Prime Lending

To understand what subprime lending is, we'll also have to talk about what prime lending is. Prime lending is based on what's called a prime rate. The prime rate is the interest rate that's issued for mortgage borrowers with what lenders deem "good credit." This rate is usually three percentage points above the federal funds rate, which is set by the government. This federal funds rate is the interest rate that banks charge other banks for overnight loans, so adding three percent to that gives you the prime rate.

House Flipping Loan Fraud

When a property is purchased and then quickly resold at a value that is artificially inflated by false appraisals, loan fraud has taken place. No significant repairs or improvements have been made to the property, and the higher resale price is not fair. Usually, the first buyer is reselling the property to someone that is participating in the fraudulent activity. What is a group of fraudsters called, a flock? A flock of fraudsters.

Disclosure Documents

Within three days of filling out a loan application, your mortgage broker or lender must provide you with a written document giving you most of the information you will need to know about the loan. (This is a provision of TILA-RESPA, but I'm sure you remembered that, Mustafa.) These disclosures are required to be provided at two major points in the mortgage transaction. Disclosures made at the very start, or point of origination, are designed to give the borrower advance notice of the loan program and the costs associated with the program. Disclosures made at the end, or loan closing, are designed to confirm for the borrower that they are receiving what they expected. If disclosures are not provided, do not do business with this lender or broker.

Chapter 6 Key Terms

✏️ subprime loan: a mortgage with an interest rate higher than prime mortgages due to the higher risk associated with a less qualified borrower ✏️ usury: laws that limit interest rates ✏️ loan flipping: a predatory lending technique that involves coaxing lendees to repeatedly refinance their loans, adding fees and prepayment penalties each time