Graduated payment mortgages (GPMs) offer initial low monthly payment options for home buyers who are in a temporary low income situation. The monthly payments of GPMs start at a lower amount than conventional mortgages and gradually increase over a period of five or ten years, at which time they peak and remain the same until the mortgage closes.

Graduated payment mortgages are often chosen by home buyers who have low incomes and who may not currently qualify for a conventional loan because of the high payments. For example, a medical school student would be an ideal candidate for a GPM because once he/she starts working in the field, the increase in salary will help pay the mortgage.

What to Expect

With a GPM you have the option of choosing a five or ten year plan which denotes the time period when the payments are reduced. With the five year plan, your payments will either increase 2.5%, 5.0% or 7.5% during the first five years. With a ten year plan, the payments will increase either 2.0% or 3.0% during the first ten years of the loan.

Home buyers who are interested in the lowest payments upfront will normally choose the 7.5% option. However, this option will result in a higher overall payment after the initial five years is complete.

Example: You apply for a $200,000 graduated payment mortgage for 30 years at 6.5%. If you chose the 2.5% option over five years, your payments would be as follows:

Year 1 – $1,144
Year 2 – $1,173
Year 3 – $1,203
Year 4 – $1,232
Year 5 – $1,263
Year 6 – 30 – $1,295

For the same mortgage with the option of 7.5% over five years, your payments would be as follows:

Year 1 – $940
Year 2 – $1,011
Year 3 – $1,087
Year 4 – $1,168
Year 5 – $1,256
Year 6 – 30 – $1,350

As you can see from the above example, the 7.5% option would result in lower initial payments than the 2.5% ($940 vs. $1,144); however, the 7.5% option would also result in a higher monthly payment once the program switches into a conventional mortgage type after five years ($1,350 vs. $1,295) . With the 7.5% and 2.5% option your payments will be $1,350 and $1,295 respectively for the rest of the loan period (25 more years).

Advantages and Disadvantages of a Graduated Payment Mortgage

Advantages

• If you are sure of an increase in your income, you can qualify for a house you wouldn’t normally be able to afford with a graduated payment mortgage.
• You will know the exact plan of how much your payments will increase before you apply for the mortgage so you can see if the payments fit within your budget.

Disadvantages

• In a graduated payment mortgage, negative amortization occurs initially since the payments you make are don’t cover the full interest due. This difference in interest will be added to the principal of the loan and continue to increase until your payment meets the interest owed. If you buy in a down market or your home fails to increase in value, your loan could be higher than what your house is worth. Pay close attention to the current market when you make a decision to apply for a graduated payment mortgage.
• A GPM will often come with higher interest rates than conventional mortgages since lenders are essentially taking a risk with negative amortization.
• You will face financial difficulties if your intended salary does not materialize when you expected and you will have trouble paying the higher payments after the five or ten years.
• If you are planning on moving out of the home in 5-10 years, this mortgage may not be the right choice for you. You are taking a chance because during the initial period you are not building equity and you are adding to the principal loan amount.

Talk with a lender to discuss your options. A GPM could land you in tough financial times if you are not aware of the risks. There are many options from which to choose including FHA loans as well as restrictions and a qualified professional can help you with choosing the right mortgage for your current financial situation and the market in which you are buying.