Payment shock is a term that lenders use to describe a situation where borrowers dramatically increase their monthly housing payment. There is no specific number for payment shock and many loan programs do not take payment shock into consideration at all. But regardless of that, payment shock occurrs when mortgage borrowers find themselves with a much higher payment that what they were previously paying.
Payment shock can take place in the case of new homeowners used to paying a small rent payment or homeowners with adjustable rate mortgages that rises dramatically from one payment to the next.
Take for example, a couple is shopping for a new home. They find a home for $250,000. Their taxes will be say, $250 per month and their insurance payment adds another $50 for a total monhly principle, interest, tax and insurance (PITI) payment of $1,600. If the couple has been making rent payments of only $600 up to that point, well, certainly that could be considered payment shock.
It does not mean that a lender would not allow that to happen. It is simply another thing that is taken into account when underwriting a mortgage. If that same couple had a monthly income of $10,000, would the increase come as a big surprise? Maybe, but do you think they could handle the new payment? Seems likely, right? But if that same couple had a monthly income of $4,000, well, then payment shock would definitely come into consideration.
Payment shock is calculated by dividing the new payment by the old payment. This gives you the percentage increase. Some mortgage programs may have a cap of 150% for payment shock. That would be a new PITI payment of $1,500 and an old payment of $1,000. If the new payment exceeds $1,500, the payment shock would go above 150% and may prevent the borrower from being approved.
Payment shock also occurs for people who took out a 2/28 or 3/27 mortgage. These mortgages where offered by most subprime lenders; they rarely exist today. The “2” & “3” refers to how many years the interest rate was fixed. After the fixed rate period, these mortgage typically increased quite dramatically.
These mortgages are at the very center (along with pay option, negative amortization loans) of the mortgage market meltdown. Borrowers were just not prepared for the increases these loans can go through. Much of the fault lies with unsavory loan officers and brokers. At the same time, many people took these loans knowing full well the possible outcome.