What is a graduated payment mortgage?

We generally divide mortgages into two groups: those with a fixed rate and those with an adjustable rate. A graduated payment mortgage is both: a loan with a fixed rate but variable, or graduated, payments.

GPMs are self-amortizing loans, meaning the debt is completely paid off at the end of the loan term. They are typically an FHA product (sometimes referred to as a Section 245 loan), requiring the borrower to pay upfront and annual mortgage insurance premiums. FHA GPM plans include:

• A 5-year initial period at 2.5 percent, 5 percent or 7.5 percent graduation
• A 10-year initial period at 2 percent or 3 percent graduation

Because of how the payments are structured, GPMs are one option for borrowers who expect higher earnings in future years, but are having a harder time meeting the debt-to-income requirements to qualify for a loan today.

How do graduated payment loans work?

To understand how graduated payment mortgages work, let’s first look at a typical fixed-rate mortgage.

A $200,000 fixed-rate mortgage, for example, with a 2.9 percent interest rate over 30 years, has a fixed monthly payment (loan principal and interest) of $832. This monthly payment remains steady over 30 years, and the entire balance will be paid off by the end of the loan term.

A GPM works differently. Say that same $200,000 mortgage, with a 2.9 percent fixed interest rate over 30 years, now comes with a 5 percent increase to the monthly payment in each of the first five years. In year six, the loan then converts to set monthly payments for the remainder of the term.

Unlike our traditional fixed-rate mortgage scenario, which has a set monthly payment of $832 for the life of the loan, this GPM example comes with a monthly payment of $673.62 in the first year. That’s a cash difference of $158.38 per month, or $1,900.56 for that year.

By year six, however, the monthly payment has increased to $859.73, or $27.73 more per month than the $832 payment in the typical fixed-rate situation.

While the end result in both instances is that the mortgage will be paid off in 30 years, the borrower with the GPM has a lower principal and interest payment for the first five, but will end up paying more in interest than if he had gone with a typical fixed-rate mortgage.

Pros and cons of graduated payment mortgages

Graduated payment mortgages can be quite complicated, so it’s hard to understand exactly how they work at first. However, there are benefits, such as lower upfront costs, that can make them beneficial to certain borrowers.

Pros

• Lower initial payments. The whole idea behind graduated payment mortgages is that the payments start off small and grow over time. If you expect to increase your income over time, this lets you get a mortgage that is more affordable to begin with.
• Easier to qualify. Because of their lower initial payments, lenders may be willing to approve GPMs more easily for people with low incomes.
• Buy a larger home. The less-strict lending requirements and lower payments can make it easier for borrowers to qualify for larger loan amounts.

Cons

• Higher overall cost. Because initial payments are low, principal is reduced more slowly, which means more interest will accrue, driving up costs,
• Complexity. GPMs are complex thanks to their changing payments and other factors. It can be harder to determine if a GPM fits your budget or is a good deal.
• Negative amortization. Your monthly payment, especially early on, may not cover the full amount of interest that accrues. That means your debt could grow at first, which could put you underwater on your home–owing more than the home is worth.
• Relies on future income growth. If your future income doesn’t increase as expected, your larger future payments could become unaffordable.

Graduated payment mortgages and negative amortization

A graduated payment mortgage can also negatively amortize depending on how high the interest rate is. (Negative amortization is a fancy term meaning the loan balance can grow instead of shrink.) This happens when the interest payment is higher than the initial monthly payment overall.

Say you again have a $200,000, 30-year GPM, but at a 5.7 percent fixed interest rate, with the monthly payment increasing 5 percent per year for the first five years.

In year one, the interest payment is actually higher than the monthly payment, which adds to the balance of the loan.

Source: DecisionAide Analytics

By year two, however, the monthly payment will have increased by 5 percent, from $949.40 to $996.87. This is now higher than the interest payment, which at the beginning of the second year is $950.04, and the balance is now being paid down instead of negatively amortizing.

Negative amortization can take place for several years at an early point in the loan term, but the mortgage will be organized in such a way that the entire balance will still be paid off by the end of term. Because the loan principal grows at the start of the repayment period, however, the mortgage will ultimately cost more.

Graduated payment mortgage requirements

Because graduated payment mortgages are most often FHA-insured, there are certain criteria borrowers must meet. These include:

• At least a 3.5 percent down payment
• FHA mortgage insurance premiums
• The loan must be for a single-unit, owner-occupied property

Adjustable-rate mortgage vs. graduated payment mortgage

While the monthly payments for both an adjustable-rate mortgage (ARM) and a graduated payment mortgage change at certain intervals, there’s a big difference between the two.

With the typical ARM, there’s a fixed interest rate during the initial period, say three to 10 years. After this period ends, the interest rate can move up or down based on an index, increasing or decreasing the monthly payment. The borrower doesn’t know whether future payments will be higher or lower, or by how much.

With a GPM, on the other hand, the monthly payment changes, but the borrower knows in advance what those changes will be according to the loan’s repayment schedule. In other words, there’s no surprise increases and or sticker shock.

Bottom line

A graduated payment mortgage has some strange aspects and makes the most sense for a borrower who expects to earn considerably more in the next five to 10 years.

More often than not, these kinds of loans cost more than a traditional fixed-rate mortgage, despite having lower monthly payments upfront, especially if it negatively amortizes initially. GPMs are also backed by the FHA, so the borrower has to pay FHA mortgage insurance premiums, which adds to the overall expense.