In today’s mortgage spotlight, we are going to take a look at Graduated Payment Mortgages. A graduated payment mortgage is defined by Mortgage Educators and Compliance as “A mortgage whose initial payments are lower than its later payments. The payments are intended to gradually increase, as the borrower’s income increases over time.” Sometimes, these mortgages are abbreviated as GPMs.

How it Works:

With a graduated payment mortgage, a borrower can have a lower monthly payment initially. In fact, normally this lower monthly payment will be less than the monthly interest on the loan. This means that the loan balance is building up interest and increasing over time. This is also known as negative amortization. (A conventional mortgage has amortization, because the monthly payments pay off and decrease the loan balance over time. Any loan that has a balance that increases rather than decreases, such as GPMs, has negative amortization.)

Graduated payment mortgages are designed to have payments that increase based on a preset schedule. Normally, this coincides with the borrower’s income increasing as well. Borrowers with career paths that have an expected increase of income over time, such as a lawyer or doctor, may be able to benefit from these mortgages. Of course, the risk here is that the future is unknown – if the borrower’s income does not increase as expected, they could end up owing more than they are able to pay.

Negative Amortization: Avoid at All Costs?

It’s good advice to be wary of loans with negative amortization. In fact, most people will tell you to avoid them if at all possible. After all, you’re making payments on a loan balance that is only increasing, which could potentially lead to a balloon or lump sum payment, which you might not be able to pay. There are cases when they could be beneficial to a borrower, however. In this case, if a borrower is able to get into a home and their income increases as expected, a graduated payment mortgage may be a good choice.

Is Refinancing an Option?

Many people will refinance their mortgage at some point in their lives, either to take advantage of a lower interest rate, reduce their loan term or payment amount, utilize funds from their home’s equity, or for a variety of other reasons. Refinancing may be an option for graduated payment mortgages as well, but you will have to discuss this with your lender, and be sure to read your loan agreement to see what it says about refinancing. Sometimes there may be a fee associated with refinancing. It’s best to discuss your options with a loan officer.

Let’s Examine an Example

Decision Aide offers a graduated payment mortgage calculator for those considering a GPM, or for those who are simply looking for more information. You can use this resource to examine different scenarios and what your payment amount may be, although of course it’s best to communicate with your loan officer about specific payment schedules.

Let’s use this calculator to create an example. Say you have a 30-year loan for $100,000, with a 7.5% interest rate. Because it’s a graduated payment mortgage, you’re starting out with a payment of $610.37 per month. This payment will increase 3.5% annually for the next five years, but will level out in Year 6 of your loan.

In Year 1, when you’re making that $610.37 payment, you are not paying the full interest amount (which is $625). This means that your loan balance is increasing – although the loan amount was for $100,000, at the end of Year 1, you will now owe $100,181.72.

In Year 2, your monthly payment increases to $631.73. This is now enough to cover your interest payment (which is now $626.14). As a result, your loan balance starts decreasing. At the end of Year 2, you owe $100,112.24.

Your monthly payment increases again in Year 3, Year 4, and Year 5. In Year 6, your payment levels out, and is now $724.92 per month. This remains steady for the remaining 24 years, until your loan is finally paid off. However, it allowed you to benefit from a low monthly payment in those first few years.

Graduated Payment versus Growing Equity

Like graduated payment mortgages, growing equity mortgages (or GEMs) have a payment schedule where the monthly payment increases over time. However, unlike graduated payment mortgages, a growing equity mortgage will never have a payment amount that does not fully amortize. In other words, you’re always going to be paying off a bit of your loan balance with each payment that you make for a growing equity mortgage.

Someone might opt for a growing equity mortgage because they are often paid off sooner than 30 years (usually in just 15). The point of a GEM is to earn equity faster. Like a graduated payment mortgage, those who have a growing equity mortgage anticipate their income increasing, and therefore expect that they will be able to afford the increase in their monthly payments. However, because they are actively earning equity and are never experiencing negative amortization, those with a graduated payment mortgage can leverage any existing equity in their home if they ever need it.

Who offers Graduated Payment Mortgages?

If you’ve been shopping for a mortgage, chances are you recognize the common products by now – conventional loans, 30-year fixed rates, sometimes adjustable rate mortgages. So, who exactly offers graduated payment mortgages?

Any FHA lender can potentially offer a graduated payment mortgage, but because of the risk associated with negative amortization, most lenders won’t advertise GPMs on their websites. If you feel that a graduated payment mortgage is something that could potentially benefit you, it’s best to reach out to a lender or loan officer directly for more information. Some top FHA lenders include Quicken Loans, Citi, New American Funding, and loanDepot!

Be sure to do your research before choosing any specific mortgage product. Graduated payment mortgages might be a good option for you if you want to benefit from a low payment now, but expect your income to rise to make higher payments in the future. However, rates are already historically low, so it might be a safer investment to opt for a conventional mortgage. Compare mortgage lenders and products right here on RateZip!