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, but it is also linked to changes in adjustable-rate mortgages and balloon mortgages.

Payment shock is a mortgage underwriting consideration because, for renters, the monthly obligation of a mortgage can be substantially higher than rent. Large housing cost increases can strain a buyer’s budget and affect their ability to meet their commitments.

So, as part of mortgage approval, lenders evaluate a renter’s potential payment shock.

When a buyer’s proposed mortgage payment is 150% higher than their current rent, their mortgage application may undergo additional scrutiny. Lenders assess the buyer’s financial stability and household income and their ability to accommodate 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 find that, at today’s mortgage rates, the PITI for their new home would be 250% more monthly than their current rent.

The home buyer can handle the new, higher payment, but their mortgage lender wants to make sure.

As part of the approval sequence, the lender reviews the buyer’s income history and savings, and asks for a letter of explanation regarding the payment increase. It also considers the buyer’s credit history of making on-time payments to credit card companies and other lenders.

The buyer’s strong rental history and financial management skills 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 prospective homeowner’s current rental payments with the expected mortgage payments. A significant increase, often over 150%, is a potential payment shock.

Can payment shock lead to mortgage rejection?

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

Is payment shock considered in refinancing?

Payment shock can also be a consideration in refinancing, particularly if the new loan term 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 thoroughly assessing their financial stability, creating a solid budget, and ensuring they have sufficient income to handle increased housing costs.

Does payment shock only affect first-time home buyers?

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