Financial Horror Stories Begin with High-Cost Lending - Part 2
Part Two of Our Predatory Financial Product Series
image Last month’s article explored financial resources needed to escape or avoid the predatory lending/financial product trap and how to avoid predatory credit repair/debt settlement companies. This month’s discussion involves four more predatory lending products – Buy Here Pay Here Auto Loans (BHPH), Refund Anticipation Loans (RAL), payday loans, and storefront signature loans.
Spooky-High Rates found at Buy Here Pay Here (BHPH) Auto Dealerships
At a legitimate dealership, most advertising will focus on the quality of vehicles and low-interest rates. However, have you ever driven by an auto dealership with signs saying no credit, no problem, no credit needed, or how about—no credit check? Have you ever wondered how such a risky business model stays in business? These businesses thrive on high-cost lending. Often these dealerships charge the consumer the legal limit of interest allowed by the state for every loan and sell their cars at or above full retail price.
Here is a comparison of two vehicle loans. In this scenario, Casey is buying a used vehicle. Casey was unsure about her credit, so she chose to buy a vehicle from a BHPH auto dealership. She was offered an interest rate of 21% and a payment of $355.48 for 60 months. No credit check was required, but she wondered if she could get a better interest rate by talking to her financial institution.
Casey called her financial institution and, though she didn’t have perfect credit, she was offered an interest rate of 12% with a payment of $292.29 for the same 60 months. After doing some quick, simple math, Casey realized the loan with her financial institution would save her $3,791.40 in interest charges.
If possible, the best way to ensure favorable credit terms is by preparing for large purchases well in advance. A little planning can give time for establishing or rebuilding credit and saving money for a down payment.
Avoiding the Ghost of Tax Season Past
Another predatory lending product is Refund Anticipation Loans (RAL), or Rapid Refunds as they are sometimes called. This product is often sold as a service and not a loan, but it is a loan. RALs are usually offered by larger tax preparation services to provide immediate access to a consumer’s tax return. This service is not free. A RAL will cost the taxpayer up to five percent of their entire tax return. Five percent may sound like a small amount, but with the average tax return for 2020 totaling $2,775, five percent equates to $138.75. According to the IRS, eight out of ten e-filers receive their return within ten days. This is 182.5% APR for a ten-day loan.
There is an additional detail that makes RALs riskier for the borrower. If the tax return contains an error, the amount advanced, may need to be repaid by the taxpayer. This repayment is required even if the error is the fault of the tax preparation service that funded the RAL. Therefore, it is far less expensive and less risky to e-file and wait ten days to receive the tax refund.
Another thing to consider is who prepares your tax return. Tax preparation is big business, and many large tax preparation services hire people without tax expertise to become tax preparers using their company’s software. For a simple tax return that contains only W2 income, you may opt to file your taxes using an online service that guides you through the process. For low-income taxpayers, many online tax resources offer their services for free or at a reduced cost. If you are a low-income filer who prefers an in-person appointment for tax filing, check the IRS website for a volunteer income tax assistance (VITA) site near you. VITA sites are managed by the IRS and use volunteer labor to prepare tax returns at no cost to the taxpayer.
Loan Pirates Looking for Loot
Sometimes it is hard to know if the loan or financial product is predatory. Many predatory lenders disguise themselves as friends of the community. When entering their place of business, they will smile when greeting customers, ask a question to get to know them, and may even “help” when times are tough. However friendly they may be, the most telling sign of predatory lending lies in the APR. Any APR in the triple digits is a predatory loan. Two predatory financial products seem to gain trust easier than most. These types of lenders are payday and storefront signature loan companies.
Payday lenders are companies that agree to make a small-dollar loan that is to be repaid plus a fee on your next payday. Borrowing once is not that expensive, but the Center for Responsible Lending (CRL) reports that 91% of borrowers cannot pay off the loan with their next paycheck. If the borrower is unable to pay in full, they are allowed to pay the fee and “reborrow” the money until their next paycheck. CRL reports most borrowers reborrow between 8-13 times before being able to pay off their loan.
Here is an example of a payday loan: Drew borrowed $300 for a fee of $35 and needed to reborrow that same $300 for ten paydays. That $300 that was paid out once by the lender cost Drew $350 ($35 X 10 paydays = $350).
Storefront signature loan companies are a bit more complicated. They work similarly to the signature loans offered by many reputable financial institutions with one glaring difference—the price. These loans are longer-term than payday loans, lasting a few months to 1.5 years. Most of these loans report to the credit bureau, and usually, payday loans do not. These loans are traditionally “renewable,” meaning that the borrower is eligible to cash out what they have paid off before the balance is paid off. However, renewing these loans comes with a high cost.
The APR for these loans can be in the triple digits, and if the loan is renewed, it restarts the loan. New fees and interest are charged for the new loan. Here is an example of how these loans work:
Blair borrows $500 for an auto repair. For the $500 loan, Blair will pay $175 in fees and interest. The payment for this loan is $65. Since the fees are front-loaded, the payoff looks like this:
Loan amount $675-payment $65= Balance $610
Balance $610-payment $65= Balance $545
Balance $545-payment $65=Balance $480
Here is when the option to renew becomes available. The company gave the borrower an original amount of $500. Now that the loan balance is less than $500, they have the option of cashing out the $20 of principle they paid off. The lender will then charge their full fees again, and the loan balance will go back up to $675. At this point, the amount the consumer has been charged for fees and interest is $350.
When a loan is renewed, it also closes the old loan and begins another, thus reducing the likelihood of building credit. The age of the accounts on credit reports determines 15% of a credit score, and 10% is new credit. If the loan only reports three months of history, that is not enough time to build credit and the new loan will be added to the credit report as a new account, which could lower the credit score.
How Credit Can Save the Day
The fact is that most predatory lending transactions begin with a financial emergency. A way to avoid the costly alternative lending cycle is to start saving and making strides toward credit building or rebuilding.
A great way to help bruised credit is by having something positively reporting to the credit bureaus. Financial institutions have a vested interest in credit building. Many offer credit building products such as secured loans where borrowers use their savings to secure a loan that reports to the credit bureaus. Many times, as payments are made, the funds in the savings account are released.
Another great way to build credit is through a secured credit card. Secured credit cards require a security deposit to establish an equal (or sometimes more) credit limit. A consumer can use this card as an “audition” for an unsecured credit card. There are a few rules that will ensure credit-building success with a secured credit card.
1. Use your card every month. On-time payments matter most in calculating credit scores, and no payments are required on zero balances.
2. Wait for the statement to pay off small balances. Payments made between billing cycles may or may not be reported to the credit bureaus. The credit card company should be able to give you the details on how and what is reported.
3. Keep balances low. Using less than 10% of credit limits at all times is ideal, but using up to 30% will still allow or credit building.
4. Always pay on time! Missed payments can derail a credit-building strategy, but on-time payments will build credit.
5. Form a strategy for using credit. It is harder to control when we don’t plan. A simple strategy like paying a small bill that is the same amount every month, like a streaming service, is a great way to build credit without stretching the budget.
Many predatory products were mentioned through this series, but a good credit score and savings can help avoid using these products and services. Of course, a healthy amount of skepticism is critical in avoiding these products as well. Especially in personal finance, if it sounds too good to be true, it usually is.
Lastly, finding reputable financial information when questions arise is another way to avoid expensive lending products. Financial institutions have a vested interest in the financial success of the people they serve. Asking them for financial resources is a great way to ensure the information can be trusted.