What Is a Predatory Business Loan? (And How To Avoid Them)
A predatory business loan imposes unfair and abusive loan terms on small business owners. To avoid these types of loans, you must understand the risks they pose, what they look like, and who’s most likely to fall victim to them.
This guide will help you learn how to protect your business and potentially stop others from falling into a similar trap.
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What Is a Predatory Loan?
Predatory business lending can take many forms, but the most common types of loans that take advantage of small business owners involve:
- Loan Flipping: This occurs when a predatory lending agency convinces a business owner to refinance an old loan, such as a personal mortgage. Refinancing may lower the monthly payment slightly, but end up costing the business a lot more in interest payments in the long run.
- Prepayment Penalties: This is a predatory lending practice in which the lender charges a high prepayment penalty. Lenders do this to discourage borrowers from repaying their loans early so the lender can capitalize on the ongoing interest.
- Hidden Balloon Payments: This predatory lending practice requires a business owner to pay off a huge balance by a certain date or risk losing their collateral while the lender also holds them financially and legally responsible for repaying the loan. This trap happens when a lender persuades a borrower that a short-term loan will mean less in interest while assuring them they can always refinance later if they can’t make the balloon payment when the loan comes due.
- Bait and Switch: This occurs when a lender advertises goods and services for a fee, but replaces them with inferior versions. The lender makes the loan sound good only to disappoint you later.
- Mortgage Servicing Abuses: This relates to strategies focused on deceptive or fraudulent mortgage services.
- Insurance Packing: This occurs when a lender slips an insurance clause into a business loan agreement. It then results in many unexpected, additional costs for the borrower.
- Equity Stripping: This relates to practices in which a business property's equity is made less attractive to lenders.
Who Can Fall Victim To Predatory Lending?
Anybody who isn’t aware of such practices can become a victim of predatory lending and inadvertently choose a predatory business loan. Yet, some groups of people — as outlined below — are more susceptible to predatory lending practices than others.
Subprime borrowers are individuals with very poor to low personal credit scores — typically lower than 630.
Predatory lenders deliberately target subprime borrowers in order to charge them high interest rates for these key reasons:
- Subprime borrowers may have a low credit score, but they still want to have a business of their own.
- Because of their low income, subprime borrowers want to lead a better life by starting their own business.
Predatory lenders often target low-income families and, as a result, these families often end up paying more for loans even if they have an excellent credit rating. Here’s why:
- Low-income families want to live a better life by starting a business so they often choose loans like bank overdrafts, car title loans, and payday loans to fund a business.
- To get the same level of funding as middle-income or high-income families, these families end up using financing from educational loans, home loans, and car loans, which can hurt their personal credit scores and force them to take business loans with terrible interest rates and high annual percentage rates (APRs).
Latino, African-American, and other minority borrowers often fall victim to predatory lending practices. Lenders target these groups due to their socioeconomic conditions and because they’re turned down for less predatory loans at a high rate. For example:
- Often neglected subsections of society, minority groups tend to be less fortunate financially and have fewer resources. Yet, these populations continue to start more and more businesses. In the last 10 years, minority businesses represented more than half of the 2 million businesses started within the United States. Many minorities have been targets of vicious predatory lending practices mainly because they’re more likely to be turned down for a traditional loan than a nonminority.
- Compared to Caucasian borrowers who receive more than 50 percent of loans issued by lenders, African Americans received just 3 percent of the total loans approved in the United States in 2019.
Military Service Members
Predatory lenders also tend to market their services heavily to military service members for the following reasons:
- Older members of the military end up starting small businesses later in life and often seek fast loan options. Many fast-loan providers are predatory lenders that often charge more interest than credit card companies — with worse terms.
- Younger members of the military often have limited credit ratings and, as a result, they have limited financing options.
People Facing a Financial Crisis
Predatory lenders constantly watch for people who need cash in a hurry because of reasons like these:
- Job Loss or Home Repairs: It could be anything, and it can lead to someone becoming desperate for cash to either start a business of their own or repair their home office.
- Business Loss: People can feel most desperate for cash if they’re trying to bring back their business to the good old days.
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Can Predatory Lending Be Harmful?
Yes, a predatory business loan can be harmful — both to the individual borrower and society as a whole. These lenders put business owners in challenging situations, making it difficult for them to stay in business let alone leverage lending to grow their companies.
The profile of a typical borrower with a predatory business loan looks something like this:
- A rising debt load
- A very poor credit rating
- Past problems with creditors and debt collectors
Ultimately, predatory loans hurt the borrower and society in several ways as outlined below.
Reduced Property Values
Predatory business loans can harm not only the borrower, but also the community. For example:
- When an office building goes into foreclosure, it brings down the property value of the entire neighborhood.
- The presence of an office building in a particular area means there’s a thriving business, which, in turn, means a lot of wealth flowing out of that area. If you add a predatory business loan to the mix, the flow of wealth will stop and that could lead to the decay of the community.
Damaged Credit Scores
Predatory business loans can damage both business credit scores and personal credit scores. When business owners lose their good credit ratings because of predatory loans, it can affect them long into the future. Some likely outcomes of this include:
- The business person may have to pay more for future business loans.
- Individuals who default on predatory business loans can ruin their chances of getting a business space or even business insurance.
Increased Debt Traps
Debt traps are one of the worst effects of predatory business loans. They imprison business owners with debt that’s impossible to repay and so their company soon goes out of business.
Here are two examples of debt traps:
- A business owner borrows a small amount of money from one predatory lending source then finds they must take out another predatory business loan from another source to pay back the first lender. This borrowing pattern continues until the business is forced to shut down because it can no longer afford to pay back its high-interest loans.
- When an individual’s business suffers financially (for whatever reason), that owner grows desperate to keep their business afloat and borrows money from everyone and anyone who’ll lend it to them. This business owner takes on so much debt that they can’t keep their business alive any longer and they eventually have to close their shop.
In addition to hurting the borrower and the community, predatory business loans also can put a dent in local economies. For example:
- Predatory business loans take from the poor and give to the rich, such as big business and large banks. This results in inequality of income and wealth disparity in the economy.
- Predatory business loans can create issues not only for the economy, but also for the financial institutions that practice such illegal methods. As a result, those financial institutions also suffer bigger losses than other banks.
How To Avoid Predatory Lending
The best way to avoid predatory lending is to increase your “financial literacy.” You can then apply your financial knowledge to help you more easily recognize predatory lending practices.
Follow these three tips to avoid predatory lending:
- Make yourself knowledgeable about financial subjects.
- Understand how your credit and income options affect your loan options.
- Get as much advice as possible regarding the business loan options you’re considering.
What Are the Warning Signs of Predatory Lending?
It’s easier to avoid predatory lending if you can see it coming. Make sure to watch out for these key warning signs.
Predatory lenders often lure in small businesses with offers that sound too good to be true. But, remember, they always come with a hidden cost. For example:
- The business loan will look attractive because it won’t require a credit check.
- The lender will promise low-interest rates, an easy approval process, and fast cash to the small business owner.
A regular lender will provide a written disclosure that outlines all the costs associated with a loan. A predatory lender, on the other hand, will try to conceal this information. For example:
- Predatory lenders will do anything to hide the costs associated with a loan, such as prepayment penalties, the APR, the term length, and fees.
- Predatory lenders will always be in a rush. They won’t provide all the information a small business needs upfront to evaluate a loan before they can proceed.
High Fees and Rates
Predatory lenders always try to offer loans to small businesses with high interest rates. For example:
- Predatory lenders will offer loans with fees that can soon add up to much more than the actual amount a small business wants to borrow. These loans also will consist of other dubious features, such as credit insurance, that come packaged with them.
- A lender may quote the interest rates on predatory loans as low percentage figures, but the APR might actually reach double or triple digits. The difference between the interest rate and the APR is something every borrower should understand. The interest rate refers to the amount of interest you’ll pay on the loan’s principal amount. While it’s also expressed as a percentage, the APR includes all the fees and other hidden charges written into the fine print of a loan agreement that most people never read — especially those in a hurry to get approved. The borrower thinks they’re paying just the interest and principle, but, in reality, they must pay loan origination fees and other hidden costs.
Many loan offers now come over the phone or through the mail — and will continue to do so. Beware of such offers because:
- Licensed, reputable lenders never sell their services through the mail or via phone. They also won’t send someone to show up at your door to sell their services.
- Predatory lenders are often unlicensed financial institutions — most of whom are private money lenders not subject to any banking laws. Avoid them because they’re just after your money.
No Required Credit Check
Predatory lenders seldom check the credit score of a small business before approving a loan. Here’s why:
- They don’t need to know what a small business can afford or how good it is at handling a debt before approving a loan because their main goal is to squeeze as much money as possible out of that business. Predatory lenders don’t care if the business suffers.
- They won’t hesitate to skip this step to extort money from a small business through unfair means, such as gaining direct access to bank accounts, using office property as collateral, or by charging exorbitant interest rates and loan origination fees. In contrast, respected lenders always check the credit score of a small business before approving a loan application.
A Damaged Credit Score
Predatory lenders, unlike reputable lenders, won’t help a small business build its business credit profile. That can not only hinder a business owner’s ability to improve their business credit, but, in some cases, can even lower their credit score. For example:
- Predatory lenders seldom report loan payments to credit bureaus, which means the small business isn’t building business credit to afford better financing options in the future. This can contribute to debt traps, as noted above.
- While a small business can’t improve their credit score by borrowing from predatory lenders, they can still damage their existing score if they fail to repay the loan and it goes to collections.
Electronic Payments Only
Reputable money lenders usually offer small businesses the option of making automatic payments whereas predatory lenders often insist on them. For example:
- Unlike licensed lenders who offer repayment options beyond automatic payments, predatory lenders frequently require you to repay the loan with automatic payments deducted from your business bank account each month.
- If a small business lacks the funds to cover a loan payment in its business bank account, predatory lenders will take payment even if it creates an overdraft in that account. This will hit the small business with hefty overdraft fees charged on a daily basis until the account is back in the black.
Unexplained Terms and Blank Spaces
This is a big no-no. Predatory lenders will send business owners a contract full of big, unexplained blank spaces and unknown clauses. Specifically:
- Predatory lenders often present borrowers with loan contracts that contain big blank spaces that they — the lender — can fill in with their own terms after the contract is signed.
- Predatory lenders often present borrowers with loan contracts loaded with unexplained clauses and terms that make no sense. This legalese often requires a contract lawyer to decipher, but, if a small business can’t afford a contract lawyer, it may fall victim to the predatory loan.
Predatory lenders will always be in a rush to complete their work as quickly as possible. They appear more like sleazy salespeople than professional loan underwriters. Specifically:
- Predatory lenders will rush you through the process of getting a loan. They won’t give you any time to think, review the terms and conditions carefully, or ask questions.
- Even if a predatory lender gives you time to review the contract and answers some of your questions, they’ll often provide vague answers or say they’ll get back to you with an answer. They’ll forget about your questions and never get back to you because they don’t want you to know the answers. If you knew the answers, you’d never sign the contract.