What to Watch Out for in Loan and Credit Contracts
Understand the terms and provisions in credit agreements and credit contracts, and learn which provisions to avoid.
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Before you sign a new loan agreement or credit contract, review the contract carefully and look for provisions that are not consumer-friendly. If your contract contains anti-consumer provisions, consider shopping elsewhere. Unfortunately, in some industries, certain types of provisions are fairly standard. If you end up signing the contract, at least you'll be aware of what you're getting into, and won't be unpleasantly surprised down the line.
This clause lets the lender declare the entire balance due (“accelerate” the loan) if you default -- that is, miss a payment or otherwise violate a term of your loan agreement (by failing to pay taxes or maintain required insurance, for example). If you miss one or two payments, the lender will probably agree to hold off accelerating the loan if you pay what you owe and pay the remaining balance on time.
Once a loan is accelerated, it’s very difficult to get the lender to “unaccelerate” and reinstate your old loan. In some states (and if the state doesn’t specify otherwise, also on loans sold to Fannie Mae or Freddie Mac), you may be able to reinstate your loan by paying the past-due amounts and fees, even after the loan was accelerated, up to five days before a foreclosure sale.
Many creditors include a provision in a loan agreement awarding them attorneys’ fees if you default and they have to sue you to get paid. If your contract contains this provision but says nothing about your right to attorneys’ fees, most states give you the right to attorneys’ fees if you are sued -- or you sue -- and you win. Several states prohibit the creditor’s attorneys from collecting a fee in excess of 15% of the amount you owed.
To make loans seem affordable, or to qualify borrowers who couldn’t afford the monthly payments when they applied for loans that required repayment in equal monthly installments for a set period, some loans are set up with regular payments too small to pay off the loan. However, they have a final large payment called a balloon payment.
Balloon payments can be dangerous. Often, borrowers with balloon payments cannot afford the large final payment when it comes due. If you don’t pay, the lender may have the right to repossess or foreclose on the property pledged as collateral for the loan -- often a house. Unscrupulous lenders or their agents may assure you not to worry because you can refinance with them before the large payment is due. Usually, however, nothing in the documents guarantees you that right.
State Prohibitions on Balloon Payments
Many states prohibit balloon payments in loans for goods or services that are primarily for personal, family, or household use; others prohibit balloon payments on loans under a certain amount. Or they give borrowers the right to refinance the loan at the lender’s prevailing rate when the balloon payment comes due. In practice, many lenders let borrowers refinance balloon payments as long as the borrowers have decent credit at the time of the refinancing. Balloon payments are not allowed in high-cost or higher-priced mortgage loans.
Confession of Judgment
A confession of judgment is a provision that lets a lender automatically take a judgment against you if you default, without having to sue you in court. Confessions of judgment are prohibited in consumer contracts. Few lenders try to include one in their loans. The laws limiting confessions of judgment don’t apply to real estate purchases, but state laws generally govern the procedures to collect on real estate mortgages.
Credit or Mortgage Insurance
Credit insurance guarantees payment of a debt if the borrower is unable to pay. It is sold by credit card companies, car dealers, finance companies, department stores, and other lenders who make loans for personal property. This type of insurance is usually a rip-off. To learn more, see Should You Get Credit or Mortgage Insurance?
Lenders make money on the interest they charge for lending money. If you pay off your loan early, they don’t make as much as they had anticipated. To make up some of the loss, some lenders impose prepayment penalties; if you repay the loan before it is due, you have to pay a penalty, usually a percentage of the balance you paid early. This makes it very expensive for you to refinance if you are having trouble making the payments or if you find a lower interest rate.
When you are shopping for a loan, make clear that you want no prepayment penalty. Before you sign credit documents, ask the creditor to show you where it states that there is no prepayment penalty, then carefully check the documents you are asked to sign. Under some state laws, prepayment penalties are allowed only on larger loans, so creditors may try to get you to borrow more money than you need so they can include a prepayment penalty. Be suspicious if a creditor offers you more money than you really need. Anytime you have a choice, get a loan without a prepayment penalty.
Pyramiding Late Fees
If you’re late on a loan payment (such as a car loan or personal loan), the lender normally imposes a late fee. These fees are generally permitted unless the lender engages in an accounting practice known as pyramiding. Pyramiding takes place when the lender assesses a late fee that you don’t pay and then applies your regular payment first to the late fee and then to partially cover the payment due. You will never fully catch up on the payments due and the lender will therefore impose a late fee every month, even when you pay on time. For the most part, pyramiding is prohibited.
Example: Sheila has a personal loan that requires her to pay $100 each month by the 5th. On May 6, when her payment has not yet been received, the bank assesses a $5 late fee. When the lender receives Sheila’s $100 payment on May 17, it applies the first $5 to cover the late fee and the remaining $95 toward her $100 payment. In June, Sheila is automatically assessed another late fee on the $5 balance due for May, even though her June payment was on time. With this scheme, Sheila will always have a slight balance—and will continually be assessed a late fee.
If you find yourself being charged a late payment in the months after you make one payment late, immediately contact the creditor, and if you can’t resolve it with the creditor, complain.
When you take out a secured loan, you give the creditor the right to take your property that secures the loan, or a portion of the property if you don’t pay. This is called a security interest. The two most common security interests are mortgages, where you give the lender the right to foreclose on your home if you miss payments, and car loans, where the lender can take the car if you default.
Some consumer loans, especially for large appliances and furniture, include a security interest in the item being purchased. Also, some personal loans that are not used to purchase a specific item -- they are often used to pay off other loans -- include a security interest in your home, car, or important items around your house. These personal loans can be hazardous to borrowers. The interest is usually very high, and if you default, the lender can take the item identified as collateral in the contract.
To protect borrowers, lenders are generally prohibited from taking a security interest in the following, unless you use the loan or credit to buy the item: your clothing, furniture, appliances, linens, china, crockery, kitchenware, wedding ring, one radio, one television, and personal effects. Some states provide borrowers with additional protections and remedies.
You have three business days to cancel most loans secured by your principal residence.
A wage assignment provision gives the lender the right to deduct past-due payments on the loan directly from your paycheck. They are prohibited in many, but not all, types of contracts. To learn more, see Wage Assignments in Loans and Credit Contracts.
Waivers of Exemptions
If a creditor sues you and gets a court judgment, or you file for bankruptcy, some of your property is protected from your creditors -- that is, it can’t be taken to pay what you owe. This property is called exempt property. It usually includes your clothing and personal effects, household goods, and some of the equity in your home and car. (To learn more, see our Property Exemptions topic page.)
Some creditors try to get around the laws that let you keep exempt property by including a provision in a loan agreement whereby you waive your right to keep your exempt property. These provisions are prohibited in most non-real-estate consumer contracts.
More and more, businesses include a mandatory arbitration clause in many types of consumer contracts, including contracts for employment, credit, insurance, and even for doctors’ services and hospital admission. These clauses require you to waive your right to go to court to resolve disputes.
Instead, you must resolve any dispute by way of a private, and often costly, arbitration system usually selected by the business. There are pros and cons to arbitration. (To learn about them, see Arbitration Pros and Cons.) But consumer advocates warn that arbitration clauses often disadvantage consumers.
Watch out for these clauses when you sign contracts. Sometimes the arbitration agreement is separate and sometimes it is hidden among the many paragraphs in a contract.
Sometimes the arbitration paragraph gives you a choice to avoid the arbitration clause, but you may have to write a separate letter saying you don’t agree to the clause. If the agreement doesn’t give you that choice, you can also tell the person you are dealing with that you don’t want arbitration. Sometimes the creditor won't require you to agree to it.
Sometimes you don’t have a choice. If you want the product or service, you have to sign a contract agreeing to the arbitration clause. If that is the case, you may want to write just above where you have to sign: “I don’t want arbitration, but I was told I could not receive the [product or service] unless I signed agreeing to arbitration.” Making it clear you did not want arbitration, but had no choice, may be helpful if there is a dispute later, and you or your attorney tries to prevent enforcement of the arbitration part of the contract.
Voluntary mediation and arbitration, on the other hand, can be helpful. These programs allow you to sue in court if you cannot resolve a dispute outside of court or if you don’t like the arbitration or mediation result.
This is an excerpt from Nolo's Solve Your Money Troubles: Debt, Credit & Bankruptcy, by Margaret Reiter and Robin Leonard.