Ask an Underwriter: What Is “Payment Shock” and Why Did You Decline My Loan?

(Image courtesy of Kick Butt Sales Training)

Most consumers don’t really understand the factors that go into a mortgage underwriting decision. And why should they? It’s not their job, it’s complicated, and they have better things to do. But one factor called payment shock is kind of a big deal, and you should probably understand it if you’re going to make your case with a mortgage lender.

Payment Shock: What Is It?

Payment shock is the degree that your housing expense will change when you take on a mortgage. It is expressed as a percentage, and it works like this: suppose that your current rent is $1,000 per month. You want to buy a house, and the principal, interest, property taxes and insurance (PITI) for that house would come to $1,500 a month. Your payment shock, then, is the new payment divided by your current expense. $1,500 / $1,000 = 1.5, or 150 percent. Many lenders will not approve a home loan when the payment shock exceeds 200 percent if other risk factors are present.

For example, in the example above, the payment shock is only 150 percent, which should be acceptable. But what if the applicant wants an FHA mortgage and the down payment is a gift from a relative? What if this person has almost no savings? Understandably, an underwriter will be concerned — the applicant is obviously spending every cent he or she earns with only $1,000 a month going for housing, so where would the extra $500 a month come from? If you’re applying for a loan under these circumstances, you’ll need an answer to this question.

How to Overcome Payment Shock

Payment shock is a common issue for young people who pay very little rent because they have roommates or live with their parents. It doesn’t take much to get to 200 percent when your share of the rent is just a few hundred dollars or less. Here are factors that can offset payment shock and help you get approved for a mortgage:

  • Good credit — many government programs like USDA, FHA and VA allow lenders to discount payment shock when credit scores are 680 or higher.
  • Conservative use of credit — if you have fewer debts, you’re less likely to get into debt over your head.
  • Regular deposits into savings — regular savings deposits demonstrate financial responsibility and good habits.
  • “Reserves,” or emergency savings that can be used to make mortgage payments — two-to-six months may be required.
  • Employment history — at least two solid years with no gaps. Increasing responsibilities and income is a plus.
  • Potential for increased earnings — include your college degree and even performance reviews if necessary.
  • Low debt-to-income ratio — keeping your other debts low can help you qualify for a larger mortgage.
  • Larger down payment — the more equity you have, the less risk to the lender.

Preparing to Buy

You can prepare to buy your first home and increase your chances of being approved by taking these steps:

  • Get used to making a higher payment before you actually have to make it. Do this with monthly savings by making the same payment each month and not spending it. So, if your current rent is $1,000, and you expect your housing expense to increase to $1,500, put $500 a month into savings for at least 12 months. You’ll get used to having less disposable income and the added savings can be used to increase your down payment or reserves.
  • Pay off credit cards and other unsecured debts. Get your debt-to-income ratios low. This should also increase your credit scores.
  • If you pay rent to family members or friends, get a rental agreement stating the amount due and keep canceled checks to prove that you pay on time and in full every month.
  • Carefully consider the effect of higher housing expenses on your finances, as well as other hidden costs of homeownership — repairs, improvements and maintenance. If you have been diverting money into paying off debts like credit cards or adding to your savings, make sure your lender knows this. Use your bank statements to prove that you have been reducing debt and / or increasing savings while paying less for housing — not blowing every paycheck on shopping expeditions and partying. Demonstrating a responsible attitude may impress lenders enough to get them to take a chance on you.