Payment Shock

Payment shock occurs when your payments rise dramatically after your initial period of low rates and payments with an adjustable rate mortgage (ARM). This phenomenon is especially likely if you have a discounted rate, such as those associated with seller buydowns. The concept might be most easily explained through an example.

First suppose you are getting an ARM whose standard rate (margin plus index) is ten percent. However, your lender has discounted the initial rate to eight percent, and the initial period of your ARM is 12 months. Further, assume that with these criteria your monthly payment during these first 12 months, at eight percent, is $476.95.

Now suppose that interest rates don’t go up at all during this initial period, so when it comes time for you periodic readjustment, you will now have an interest rate of ten percent (your discount has ended). Your monthly payment will now be $568.82. This may be a sizeable increase for you, but may not actually be enough to meet the “payment shock” level.

However, suppose now that during your first year the interest rate does not stay constant, but has risen two percent at the time of your readjustment. Rather than paying a discounted eight percent rate as you did in year one, you will now be paying a twelve percent rate in year two. Your monthly payment will increase from $476.95 to $665.43. This is an increase in monthly payments of almost $200 per month. Such a drastic jump constitutes payment shock, and can be a serious negative consequence of a discounted ARM.

Some ARMs have features that help minimize this problem, such as caps on periodic interest rate increases and caps on monthly payment increases.