How to Calculate Payment Shock

By Markets Fool.com

Many homeowners use adjustable-rate mortgages to finance their homes. The advantage of ARMs is that their rates can be lower than you'd pay on fixed-rate mortgages. However, ARMs have a couple of provisions that can result in a big increase in your monthly payment. That situation is known as payment shock, and calculating the potential impact on what you'll owe on your mortgage is vital in order to make sure you'll still be able to afford your payments.

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Two situations in which payment shock comes up
There are two common situations in which a mortgage borrower will face payment shock. The first is something that all ARMs share and occurs when the interest rate on the mortgage loan resets. If the benchmark interest rate that the mortgage uses to establish the rate you pay on the mortgage goes up, then your monthly payment will rise.

The second situation involves mortgages that have an initial period during which the borrower pays only interest on the loan. After a set period, the mortgage recasts, and the borrower must start making payments that will gradually reduce the outstanding principal on the loan. Even if the interest rate doesn't change on the recast date, there will almost always be a substantial payment shock because you'll have to add more money to pay down your principal balance over time.

Calculating the number
In order to calculate the amount of the shock, you'll need to anticipate the amount of the new payment. You can generally do this with a mortgage calculator that allows you to input the outstanding principal, mortgage rate, and remaining term of the loan in months.

For example, say you took out a 30-year ARM five years ago with an initial rate of 3%. The rate on which the ARM is based has risen to 4%. In order to determine your new monthly payment, you'll take your remaining unpaid principal balance as the loan amount and 4% as the new rate. You'll calculate payments based on a 25-year term, because you're five years into your 30-year mortgage.

Once you have the payment, the payment shock is equal to the difference between the new payment and the old one.

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Be prepared
Good mortgage professionals should anticipate questions about ARMs and payment shock by running typical scenarios based on multiple assumptions about the future. The best time to figure out what the payment shock will be is at the time you get the mortgage, not when the reset or recast is about to occur. By knowing what you're getting into, you can avoid the shocking aspect of payment shock and prepare for it as part of your overall financial plan.

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