You may have heard the phrase “payment shock” get thrown around by your loan officer or mortgage broker, and for good reason. It plays an important role in the underwriting and eventual outcome of your mortgage application, and can make or break your chance of approval.
Payment shock can be defined in a number of ways, but it is essentially any significant increase in monthly liability that heightens the risk of loan default. In simple terms, the more you need to pay out each month to creditors, the higher the chance you’ll be unable to make a payment, especially if you’re not used to making large payments.
So let’s assume your only history of carrying debt involves a car lease payment of $199 a month. If you applied for a home loan that carries a payment of $4,000 a month, payment shock would occur as you wouldn’t be used to shelling out such a large amount of money each month. And this alone could be reason enough to get denied that mortgage you’ve got your eye on.
Payment Shock Threshold
Many banks and mortgage lenders have a certain payment shock threshold that they allow, which can be dependent on things like documentation type and other compensating factors. Typically, max payment shock may be set at 200%, meaning your monthly mortgage payment can be no more than double your current housing payment. So if you currently pay $1,000 in rent each month, your max mortgage payment cannot exceed $2,000, or it may be subject to review or denial.
This is why credit history (and housing payment history) is so important, as it proves your ability to repay loans and carry large amounts of debt over time. So those with little established credit will often face a series of hurdles when looking to get approved for a home loan (or any other type of loan) because they haven’t demonstrated the ability to handle large monthly payments. This can be especially true for those living at home with mom and dad that have no previous rental history.
Payment shock can also apply to specific home loan programs, such as hybrid adjustable-rate mortgages that start with a low initial teaser rate and reset to much higher rates once the fixed period ends. A perfect example of this is the option arm, which typically begins with a 1% rate and can quickly jump up to a mortgage rate of 8% or higher. In this case, the borrower would experience payment shock for the sheer fact that the payment would increase exponentially.
Can You Qualify at the Fully Indexed Rate?
For this reason, mortgage underwriters typically qualify borrowers at the higher fully indexed rate to determine if they can actually handle those mortgage payments once the loan resets.
Most borrowers can afford the ultra-low 1% start rate, but not everyone may be able to keep up with the payment associated with an interest rate of 7-8%. So it’s important to ensure that applicants are qualified for both payments.
That said, it’s important to establish a solid credit history early on, which will prove both your ability to make on-time payments and carry large amounts of debt.
If you aren’t able to provide this, you’ll likely need to come up with strong compensating factors, such as the capacity to put more money down or document substantial income and assets that prove you’re a worthy borrower regardless.
Tip: Make sure you can document 12-months of housing payments made prior to your mortgage application.