Payment Shock: What It Means, How It Works

What Is a Payment Shock?

A payment shock refers to a dramatic increase in an individual's debts and liabilities that may cause them to default on their financial obligations. Put simply, payment shock occurs when, rather suddenly, someone is obligated to pay more in monthly debt than they can afford from their income.

This concept is commonly used to demonstrate how much more a borrower has to pay to a lender when they take out a mortgage. Payment shock is also the risk associated with certain variable-rate or teaser-rate mortgage products, including payment-option adjustable-rate mortgages (ARMs) and interest-only loans with a balloon payment.

Understanding a Payment Shock

A payment shock can result from many different factors. It may be caused by changes to an individual's financial situation—such as a decrease in income or unemployment—changes to interest rates and payment structures, or when an individual makes changes to their debt structure, such as when they move from renting to owning a home.

Lenders often calculate the payment shock borrowers are likely to experience when they first take out a mortgage or refinance. They measure a consumer's ability to pay back debt using various calculations, including the 28/36 rule, which states that a household should spend no more than 28% of its gross monthly income on housing expenses, and no more than 36% on debt servicing, including housing and other debt such as car loans.

Interest rate changes are one of the major causes of payment shock. Mortgage borrowers—notably those with adjustable-rate mortgages (ARMs)—commonly experience the following scenarios that may lead to this risk:

• The expiration of an initial or temporary interest rate
• The end of a fixed interest rate period
• The end of an interest-only payment period
• The recasting of a payment option ARM
• An increase in an ARM's fully indexed interest rate

Consumers are generally drawn to ARMs because of the relatively low initial monthly payments. They may believe the mortgage will remain affordable. However, these payment structures can backfire if the increase in scheduled payments exceeds the amount the borrower can afford to pay each month.

Special Considerations

Financial institutions use calculations to determine an individual's payment shock threshold and to determine who they will offer to finance. A payment shock threshold is based 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. For instance, someone who pays $1,200 monthly on rent may experience a payment shock of $400 or 133% on housing expenses alone if they take out a mortgage that requires them to pay $1,600 each month.

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. The current housing payment may be either a mortgage or rent expenditure. Credit scores and cash flow are also key factors that are taken into consideration when it comes to 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 to prevent payment shock. These loans tend to be more traditional and conservative, such as fixed-rate mortgages and ARMs with lifetime caps.

The Bottom Line

Managing personal finances can be difficult. You may lose your job or your wages may be cut, making what was once affordable now unaffordable. Additionally, unforeseen circumstances, such as emergency medical bills might make meeting other financial obligations difficult.

A mortgage may seem like a steady monthly payment, but if any of the above occurs, it may be difficult to meet the loan obligations. If you have a variable-rate mortgage and the interest rate environment changes against you, for example, your monthly mortgage payments may shoot up.

When taking on a mortgage, ensure you understand the terms and what the possible adverse outcomes may mean for you, and if you will be able to meet them. If you are having trouble, reach out to your lender and see if a solution can be made before missed payments add up.