Graduated payment mortgages: What are they and how do they work?
Key takeaways
- A graduated payment mortgage, or GPM, comes with monthly payments that start small, but increase over time and eventually stabilize.
- GPMs often negatively amortize at first, meaning your balance grows. You’ll still pay off the loan within the set term.
- You’ll typically find graduated payment loan options backed by the Federal Housing Administration (FHA).
A graduated payment mortgage is relatively unusual. These loans have fixed rates, but varying monthly payments. By the time the graduated payment loan’s term ends, you’ll have paid the balance in full, but the loan’s balance could rise or fall at different times over the life of the loan. Here’s what you need to know.
What is a graduated payment mortgage?
We generally divide mortgages into two groups: those with a fixed rate and set monthly payments; and those with an adjustable rate and variable monthly payments. A graduated payment mortgage, or GPM, combines elements of both: a fixed rate but variable, or graduated, payments.
GPMs are self-amortizing loans, meaning you’ll completely pay off the debt at the end of the loan term. They are typically an FHA product (sometimes referred to as a Section 245 loan), which require the borrower to pay upfront and annual mortgage insurance premiums.
How do graduated payment loans work?
FHA graduated payment mortgages can be structured as:
- 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
To better understand how a graduated payment mortgage works, let’s first look at a typical fixed-rate mortgage.
A $320,000 fixed-rate mortgage, for example, with a 6.8 percent interest rate over 30 years, has a fixed monthly payment (loan principal and interest) of $2,086. This monthly payment remains the same over 30 years, and the entire balance will be paid off by the end of the loan term.
Graduated payment mortgage example
Say that same $320,000 mortgage, with a 6.8 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.
| Year | Monthly payment | Balance |
| Source: DecisionAide Analytics | ||
| 1 | $1,714 | $321,232 |
| 2 | $1,800 | $321,489 |
| 3 | $1,890 | $320,651 |
| 4 | $1,984 | $318,584 |
| 5 | $2,083 | $315,144 |
Unlike our traditional fixed-rate mortgage scenario, which has a set monthly payment of $2,086 for the life of the loan, this graduated payment mortgage example comes with a monthly payment of $1,714 in the first year. That’s a cash difference of $372 per month, or $4,464 for that year.
By year six, however, the monthly payment has increased to $2,187 or about $100 more per month than the payment in the typical fixed-rate situation.
Graduated payment mortgages and negative amortization
In the above example, you might notice that the balance increases at first, then begins to decrease. This is known as negative amortization. Negative amortization happens when the interest payment is higher than the initial monthly payment overall. Here’s how that would shake out in terms of principal, interest and balance in year one:
| Month | Monthly payment | Interest | Principal | Balance |
|---|---|---|---|---|
| Source: DecisionAide Analytics | ||||
| 1 | $1,713.83 | $1,813.33 | -$99.50 | $320,99.50 |
| 2 | $1,713.83 | $1,813.90 | -$100.07 | $320,199.57 |
| 3 | $1,713.83 | $1,814.46 | -$100.63 | $320,300.20 |
| 4 | $1,713.83 | $1,815.03 | -$101.20 | $320,401.40 |
| 5 | $1,713.83 | $1,815.61 | -$101.78 | $320,503.18 |
| 6 | $1,713.83 | $1,816.18 | -$102.35 | $320,605.53 |
| 7 | $1,713.83 | $1,816.76 | -$102.93 | $320,708.46 |
| 8 | $1,713.83 | $1,817.35 | -$103.52 | $320,811.98 |
| 9 | $1,713.83 | $1,817.93 | -$104.10 | $320,916.08 |
| 10 | $1,713.83 | $1,818.52 | -$104.69 | $321,020.77 |
| 11 | $1,713.83 | $1,819.12 | -$105.29 | $321,126.06 |
| 12 | $1,713.83 | $1,819.71 | -$105.88 | $321,231.94 |
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 the graduated payment loan 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 you’ll need to meet:
- Make at least a 3.5 percent down payment
- Pay FHA mortgage insurance premiums
- Use only for purchasing a single-family, owner-occupied property
Pros and cons of graduated payment mortgages
When deciding whether this type of loan is right for you, consider the advantages and disadvantages:
Pros
- Lower initial payments: The whole idea behind a graduated payment mortgage is that the payments start off small and grow over time. If you expect your income to grow in the future, this allows you to get a mortgage that’s more affordable to begin with.
- Possibly easier to qualify for: Because it comes with a lower payment to start, a lender might be more willing to approve a GPM, rather than a fixed-rate loan, for a borrower with a lower income.
- Potentially get 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 the initial payments are lower, you’ll reduce your principal more slowly, which means you’ll accrue more interest.
- Complexity: Because of how it’s structured, it can be harder to determine if a graduated payment loan fits your budget, or you’re getting a good deal.
- Negative amortization: Your monthly payment, especially early on, might 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 income doesn’t increase as expected, the higher future payments could be unaffordable.
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 an ARM, there’s a fixed interest rate during the initial period, which typically ranges from three years 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.
Should you get a graduated payment mortgage?
Consider these questions if you’re thinking about whether a graduated payment loan is right for you:
- Are you expecting to earn more income or get a large amount of money (like access to a trust) in the future, where you’d be able to afford higher payments?
- Are you having trouble meeting the debt-to-income ratio and cash flow requirements to qualify for a loan today?
Remember: While a graduated payment mortgage might seem like a surefire way to get into a home for less money now, you’ll ultimately end up with a higher payment. You’ll need to be comfortable handling the monthly amount not just now but also at the top of your graduated payment plan.
There are other, more readily available types of mortgages with more affordable payments and other flexible features, too, including ARM or a physician loan.
