By Dana Dratch
If your credit is damaged but you need cash, you might be tempted to accept a loan without worrying too much about the terms. But some conditions and clauses should make you reconsider your options.
"There are some extremely abusive, one-sided contract terms consumers sign because they think that's what they have to do to get the money," says Jean Ann Fox, director of consumer protection for the Consumer Federation of America. But often you can find a better deal if you shop around.
Here are some loan conditions that should make you think twice:
1. Money upfront. "Money upfront is a really bad sign," says Fritz Elmendorf, vice president of communications for the Consumer Bankers Association, a financial services trade group. "Possibly even of fraud." One nominal application fee is fine, he says. But the point of a loan is that they are supposed to be giving you money, not the other way around.
2. Changing interest rate. An adjustable-rate mortgage can be a good thing for some borrowers. But it should be a trade-off. In return for accepting a little uncertainty, the borrower gets favorable terms, like a lower rate. Too many times in the subprime market, borrowers are saddled with adjustable-rate mortgages simply as the cost of getting a loan, says Michael Stegman, professor of public policy and director of the Center for Community Capitalism at The University of North Carolina at Chapel Hill.
If you have a rate that can change, you have to ask some questions. "You want to know what is the worst-case scenario, not best," says Norma Garcia, senior attorney with Consumers Union. "What's the worst this can get? Will that be OK?"
Realize that a changing rate makes the loan a much riskier proposition for you. In a recent study of subprime mortgage refinance loans, ARM features boosted the chances of foreclosure by 49 percent, Stegman says.
3. Balloon payment. "The ideal is: Don't have any balloon payments," says John Taylor, president and CEO of National Community Reinvestment Coalition, a trade association of community groups. The worst scenario: The balloon is due early in the loan. "It makes a huge amount of money due right away, and most people in the subprime market really can't afford to do that. So for a lot of people, they end up losing everything."
In subprime mortgage refinance loans, borrowers with a balloon payment have a 46 percent greater chance of foreclosure, says Stegman.
4. Too much money. More is not always better. So raise the red flag if a lender is trying to talk you into a larger loan. Two red flags if your home is the collateral. If you have to borrow, take the least amount for the shortest time period with the lowest APR.
5. Excessive fees. "Some fees are truly legitimate," says Garcia. "Some are backdoor fees that don't appear in the disclosure." What you want to watch out for is excessive or hidden fees. Add everything up yourself. The sum of the terms you shopped should equal what's in the loan documents. If it doesn't, you need to ask some questions.
"The title insurance policy should be something competitive," says Taylor. And if you're refinancing, you should get a refinance rate on the policy -- often half the cost, he says. "In terms of points, you shouldn't pay more than 1 to 2 points even in subprime situations. You can find competitive subprimers who will make you loans at those rates."
6. Additional services you don't want or need. Some loans are bundled with insurance policies to pick up payments or pay off the loan if you die or become disabled. Assuming you want the coverage (and can't get it cheaper from your insurance company), the problem is that many times you pay for the entire policy upfront and it's rolled into the loan with interest, Taylor says. So if you refinance that 30-year mortgage after five years, you'll have paid for 25 years of insurance that you won't use and can't recoup. If you want the feature, look for a pay-as-you-go version.
7. A credit card that taps your home equity. You don't want to squander home equity on a thousand little everyday purchases, says Garcia. "That's a real scary prospect."
8. High interest rate. The difference between prime and subprime rates will vary with the length and type of loan. With a mortgage, 5 percent to 6 percent above prime and "it's time for the customer to look around and see if they can do better," says Allen Fishbein, director of housing and credit policy for Consumer Federation of America.
Even if your credit is bad, shop around and be sure to include a credit union and a bank that makes both prime and subprime loans on your list.
9. No minimum loan term. Often with a payday loan, the entire loan (interest and principal) is due very quickly, says Fox. That means the borrower will be borrowing again just to keep pace with the debt, creating a never-ending cycle.
10. Requires a valuable asset as collateral. It may seem obvious that car-title lenders and pawn shops are a gamble because you risk losing the item if you can't come up with cash you already don't have. But consumers think nothing of putting their houses on the same block with a home equity loan or line of credit. "The worst are home equity second mortgage loans, all of the loans that are secured by the roof over your head," says Fox.
11. Binding mandatory arbitration clause. What is this? Before you sign for the loan, you forgo any rights to sue for any reason and instead agree to binding arbitration. The problem: Many consumer advocates believe that arbitrators' decisions tend to favor the lenders and deny borrowers the right to due process.
Some of the big lenders are moving away from arbitration clauses, says Fishbein. But they're still around in the subprime market.
"This should be freely entered into at the time of dispute, not as a condition for obtaining the loan," he says. "By agreeing to this provision if a dispute should arise, the table is tilted toward the lender."
12. Prepayment penalties. For the borrower, this fee "adds to the cost of credit," says Fishbein. Reason: If your financial situation or credit improves, you can't refinance your loan at a better rate. "It's one of the features we find particularly bothersome in subprime loans," says Fishbein.
Some credit experts advise avoiding prepayment penalties altogether. Others caution that one year is fine. Still others recommend keeping it to three years or less.
Prepayment penalties also increase the odds of foreclosure, says Stegman. In his study of subprime refinance loans, consumers with prepayment penalties of less than three years had a 15 percent higher rate of foreclosure. With three years or more, the numbers went to 20 percent.
And make sure the loan doesn't use the Rule of 78 to calculate interest. It's an antiquated method and "a hidden prepayment penalty," Fox says. What you want to see instead: the word "actuarial." That means "you pay for credit for the actual length of time you use it," she says.
13. Balance transfer fees. "Depending on how much you're transferring, it can be a lot of money," says Garcia. "It's something that's really easy to overlook and can cost you hundreds of dollars."
14. The lender solicited you for the loan. Face it, you get the best terms when you shop around and compare. If you're just accepting what was offered, you probably could do better.
15. Teaser rates. Who are they teasing? The person whose name is on the bill. Read the fine print, and go with a lender who's willing to give you a good rate and stick with it.
16. It comes with a free vacation. "If it's a product that's that good, you don't have to add something to make it attractive," says Garcia.
17. High pressure tactics. Are you being urged to sign immediately? "Don't do that," says Garcia. Instead, have a third party look through the paperwork. Some possible candidates: an accountant, lawyer or someone at your local bank (if they aren't making the loan). Or call a local credit counselor affiliated with the National Foundation for Credit Counseling or the Association of Independent Consumer Credit Counselors.
"If it's good today, it will be good tomorrow," says Garcia.
18. The lender is focused on your assets, not your income. Whether you're pledging your car title or your home equity, if you're a bad risk and the lender doesn't care, that should set off the warning bells. "The biggest thing that would send me running: 'no job, bad credit, bankruptcy -- no problem because you have equity in your home,'" says Garcia. "If you don't have income, you're going to default, and you will be out of your home."
19. A slew of "little" red flags. You may be able to negotiate a couple of unfavorable terms. But if the contract is loaded with them, you might just want to walk. A multitude of bad loan terms in combination could create a financial disaster.
The most dangerous triumvirate: an adjustable rate, prepayment penalties and balloon payments. "You really don't want to have these combinations of terms," says Stegman. Not only are you setting up a financial risk, but you're also limiting your escape options.
20. Terms you don't understand. Loans have gotten a lot more complicated. And with the addition of concepts like interest-only loans, adjustable rates and negative amortization, you might feel like you need an economics degree just to shop around. The truth is you might be better off with a more standard loan.
"Borrowers have to be asking a lot more questions than they were before," says Fishbein. Especially tricky: What's the payment, how often will that change and what's the worst that it could get? And if increases are capped, does that mean the lender will add payments to the end of the loan?
"You need to do the math," he says, "and ask a lot of questions."