What is Payment Shock?

Payment shock refers to a significant and abrupt increase in a first-time home buyer’s monthly financial obligations, particularly when transitioning from renting to owning a home.

A Longer Definition: Payment Shock

Payment shock is a mortgage industry term describing a sudden increase in a person’s monthly financial obligations, usually when a renter transitions from renting to owning. It is also linked to changes in adjustable-rate mortgages and balloon mortgages.

Payment shock is an important mortgage underwriting consideration. For renters, the monthly obligation of a mortgage can be significantly higher than rent. A large increase in housing costs can strain a buyer’s budget and affect their ability to meet financial obligations.

As part of the mortgage approval process, lenders evaluate the potential for payment shock when reviewing a renter’s application.

If a buyer’s proposed mortgage payment is 150% higher than their current rent, their mortgage application may receive additional scrutiny. Lenders assess the buyer’s financial stability, income, and their ability to handle higher monthly payments.

Payment Shock: A Real World Example

Imagine a first-time home buyer with a long history of renting, a perfect payment history, and a desire to buy a place of their own. They apply to get pre-approved for a mortgage and discover that, at current mortgage rates, the PITI for their new home would be 250% more than their current rent.

The buyer feels confident they can handle the new, higher payment, but their mortgage lender wants to ensure they can do so.

As part of the approval process, the lender reviews the buyer’s income history and savings. They request a letter of explanation about how the buyer plans to manage the payment increase. The lender also evaluates the buyer’s credit history to check for a pattern of on-time payments to credit card companies and other lenders.

The buyer’s solid rental history and strong financial management give the lender confidence to approve the mortgage and move forward.

Common Questions About Payment Shock

How is payment shock calculated?

Payment shock is typically calculated by comparing the current rental payments with the expected mortgage payments. An increase over 150% is often considered significant and may be classified as payment shock.

Can payment shock lead to mortgage rejection?

Yes, severe payment shock can result in additional scrutiny of a mortgage application. It could potentially lead to loan rejection if the lender considers the risk too high.

Is payment shock considered in refinancing?

Payment shock can be a factor in refinancing, especially if the new loan term would significantly increase the borrower’s monthly payments.

How can first-time home buyers prepare for payment shock?

First-time home buyers can prepare for payment shock by assessing their financial stability, creating a budget, and ensuring they have sufficient income to handle increased housing costs.

Does payment shock only affect first-time home buyers?

Payment shock is most commonly associated with first-time home buyers transitioning from renting to owning. However, it can also affect current homeowners who are upgrading to a more expensive property or refinancing under less favorable terms.