What is 'Payment Shock'
Payment shock is the risk that a loan's scheduled future periodic payments may increase substantially and may cause the borrower to default on the loan. Payment shock is a risk with many popular mortgage products, including payment option adjustable-rate mortgages (ARM) and interest-only loans.
BREAKING DOWN 'Payment Shock'
Payment shock can be the result of several things, including the expiration of an initial or temporary initial interest rate, the end of a fixed-interest rate period, the end of an interest-only payment period, the recasting of a payment option adjustable-rate mortgage (ARM) or an increase in an ARM's fully indexed interest rate.
Consumers, drawn to these mortgages because of the relatively low initial monthly payments, believe the home mortgage will remain affordable. However, these payment structures can backfire on borrowers if the increase in scheduled payments is beyond the point where they can comfortably pay each month. Borrowers should understand the structure and real numbers of the loans they are considering, but also the concept of payment shock to avoid defaulting on a loan or getting into a financially unstable position. Lenders do not want borrowers to default on their mortgages, so they are invested in preventing payment shock.
Calculation of a Borrower's Payment Shock Threshold
To prevent mortgage loan default, lenders will not lend to a borrower they do not think can support the monthly payments. They have devised several measures to calculate the risk of borrower default. One such measure is the 28/36 Rule for calculating the amount of debt that can be taken on by an individual or household. The Rule states that a household should spend a maximum of 28% of its gross monthly income on total housing expenses and no more than 36% on all other total debt, including housing and other debt such as car loans.
Financial institutes use calculations to determine an individual's payment shock threshold and to determine who they will offer to finance, and who they will not. Payment shock threshold has a basis on the idea that a borrower, already paying significant monthly housing payments, can handle an even more substantial payment. A borrower may be a victim of payment shock and loan default if they currently have a modest housing payment and new monthly commitments are significantly higher.
Banks or mortgage lenders create their threshold formulas to determine if the ratio of current home loan payments to proposed mortgage payments is low enough to prevent payment shock. However, it is common for lenders to refuse to finance a borrower whose payment will be 200-percent, or more, of the current housing payment. The current housing payment may be either a mortgage or rent expenditure. Also, the consideration of credit scores and cash flow factor into the allowable payment shock threshold calculation.
This calculation does not mean that a borrower with a low current housing payment will not be able to qualify for a mortgage. Instead, the calculation is used to guide the borrower into the correct loan type, which may be a more traditional and conservative loan. Conservative loans include fixed-rate mortgage (FRM) and adjustable rate mortgages (ARM) with a lifetime cap that prevents payment shock.
Fixed-rate loans do not carry the risk of payment shock which comes with the scheduled increase in payments or interest rates. ARMs with lifetime caps have limits on the amount of interest a loan may have.