[insert Twilight Zone scary music here]
You have entered the Twilight Loan
Beyond this world strange things are known
Use the key, unlock the door
See what your fate might have in store

Now that we are in the Twilight of the great real estate boom of the new millennium, it’s a good time to take stock of a term that more homeowners are becoming familiar with in the US of A. As mentioned in our previous entry, more middle class homeowners are faced with payment increases than is usual historically.

Payment Shock!

Payment Shock is what the populace holding adjustable rate loans is the prime mover behind refinance activity today, and in the mid-term future (think 1-3 years). There are two primary types of payment shock. This first relates to adjustable rate mortgages, the second relates to home purchases by first time buyers.

An excellent definition of Payment Shock is located at realestateagent.com:

A very large increase in the payment on an ARM that may surprise the borrower. The term is also used to refer to a large difference between the rent being paid by a first-time home buyer and the monthly housing expense on the purchased home.

As a residential loan originator, my personal opinion is that payment shock is anytime that a monthly payment increases to 200% of the prior payment on a loan under $200,000 (payment doubles) and 150% increase of the prior payment on loans greater than $200,000 due to the greater obligations that arise from these loan adjustments (payment rises 50% above past payment).

Let’s start with the most common form of shock, the 2/28 Adjustable Rate Mortgage loan. This is something experienced by many homeowners who have Sub-Prime characteristics in their lending profile or purchase properties which have traits undesirable to lenders or prospective buyers (condominium that Fannie Mae won’t warrant, unique property like a duplex in a commercial zone, etc.) Typically, these loans are issued with 2% initial interest cap and a fully indexed rate that is already at or near the capped initial interest adjustment level.

Our example in this category, the Interest Only loan you obtained (with 2/1/6 caps, 5% margin and 5.38% 6 month LIBOR index) for $100,000 at 6% costing $500 per monthly payment is now costing $746.76 to pay at 8% with a 28 year amortization schedule. Payment Shock factor 145% of original payment. Not too bad 😉

This type of loan offers the rewards of home ownership to a group of people who were long term renters in bygone days. However, with the higher interest rates in this category of loans today, someone with even fair credit cannot obtain this type of 6% initial rate loan right now. Part of the reason for real estate’s soft sales picture is the prevention of this type of borrower from getting their first home loan.

Our next installment on this topic will be published on Saturday, then we’ll skip ahead and post the next article on Payment Shock promptly on Monday morning.