You want to buy a house now. But what if you don’t have much income (at least not yet)? One of your options is a graduated payment mortgage.
Graduated payment mortgages (GPMs) are a type of home loan. The payments on a GPM start small and get larger as time goes on. This type of mortgage has a fixed interest rate. The payments increase, often between 7 – 12% each year, until a maximum payment amount is reached. This continues for the rest of the life of the loan. Most GPMs are insured by the Federal Housing Administration (FHA).
What are the Details of a Graduated Payment Mortgage?
A graduated payment mortgage is designed to start with the homeowner owing minimum payments. Then, over time, the payment amount increases. A low initial interest rate is used to qualify the buyer. This lower rate allows people who might not otherwise qualify for a home mortgage to be eligible. This type of mortgage can be a good option for homeowners whose income levels are likely to rise gradually.
A graduated payment mortgage may or may not be a negative amortization loan. This means the initial payment amount is less than the accruing interest on the mortgage loan. With a negative amortization loan, the payments the borrower makes are less than the interest charged on the note. This less than interest payment structure creates deferred interest which adds to the total principal of the loan.
Graduated payment mortgages are only available on loans from the Federal Housing Administration (FHA). FHA loans are ideal for low-to-moderate income borrowers. They are especially well suited to those who are unable to make a large down payment. FHA loans allow borrowers to finance up to 96.5% of the home’s value.
How Do the Graduated Payments Work?
A GPM loan starts with low initial payments. The payments gradually increase by some percentage each year until it levels out to a final, fixed percentage. GPMs are available in 15- and 30-year loans. All Federal Housing Administration (FHA) lenders can offer GPMs.
For example, let’s say you have a 30-year mortgage. The monthly payments increase by 5% each year for the first ten years. After those ten years, the rate will have leveled out and will no longer increase. You now have to pay this new, higher monthly rate for the rest of the loan—in this case, 20 years.
What Kinds of Graduated Payment Mortgage Options Are Available?
There are five FHA graduated payment mortgage plans. Three of them allow mortgage payments to increase. The payments increase at a rate of 2.5 percent, 5 percent, or 7.5 percent during the first 5 years of the loan. The other two plans increase payments at a rate of 2 – 3 percent annually over 10 years. Beginning in the sixth year of a 5-year plan and in the eleventh year of 10-year plan, payments level out for the remaining years of the mortgage.
Who Is the Ideal Borrower for a Graduated Payment Mortgage?
The best candidate for a graduated payment mortgage is someone who may not currently be able to afford large mortgage payments. Instead, this person realistically expects their income to increase over the next 5 to 10 years. For example, young doctors looking to buy a home (especially medical school graduates) are great candidates for a GPM.
These young professionals may not have many assets now. These people include graduate students, entry-level lawyers, bankers, or doctors. They may also include other professions with a predictable rate of advancement.
For example, most doctors will enjoy a large boost in income after they finish their residency. A graduated payment mortgage might be a great option for this type of upwardly mobile professional.
Who Is Eligible for a Graduated Payment Mortgage?
Any person who is able to meet the credit requirements, cash investment, and mortgage payment is eligible to apply. However, this FHA loan program is limited to owner occupants. In other words, a GPM is available to anyone who anticipates their earnings to increase substantially. The homebuyer must also use the mortgaged property as their primary residence.
Graduated Payment Mortgage Pros and Cons
Graduated Payment Mortgage Pros
A graduated payment mortgage can be the perfect solution for young people just starting a promising career. It’s a smart choice for those who have a stable job with an upward trajectory. This can be especially true if you’re in a career field you have no plans to leave. Some of the pros of a GPM include:
Eligibility is usually based on the borrower’s ability to pay the initial (low) payments.
Allows individuals with limited income to buy a house or a larger house than they could usually afford.
A good option for young families or other borrowers who expect an increase in income.
Gives you the opportunity to be a homeowner earlier than with some conventional mortgages.
Low mortgage payments during the first years give you room to save and spend.
Graduated Payment Mortgage Cons
Some GPMs may be negatively amortizing. That means it allows payments that are lower than the interest charged on the loan. Negative amortization can actually add to the loan’s principal. Here are some other drawbacks to a GPM:
You have to be able to meet the rising mortgage payments and budget accordingly. Higher payments might not be sustainable if your income doesn’t increase as quickly as expected. So you have to realistically predict how much you will earn in the future. It’s the only way to determine if you can pay the increasing mortgage payments.
Some GPMs have prepayment penalties.
The total cost of the GPM will likely be more than that of a conventional mortgage. You you can end up paying quite a lot more than you would with a traditional mortgage.
If your income doesn’t grow along with the mortgage payments, you will find yourself in financial trouble.
Changing careers or jobs can be risky since your mortgage payments will continue to increase.
What Are the Risks of a Graduated Payment Mortgage?
The main risk of a GPM is that your income might not rise as quickly as predicted. In this case, you’ll have increasingly large mortgage payments you’re unable to afford. So, it’s a good idea for GPM borrowers to do the math. If your earnings don’t grow the way you expected, be sure you can still afford the mortgage in future years.
Also, be aware that over the life of the mortgage, you will pay more in interest. Choosing a mortgage with payments that remain the same over the life of the loan will cost you less in interest.
Why Consider a Graduated Payment Mortgage?
If your income is currently limited, but won’t always be, a graduated payment mortgage could be a great option. But be aware that basing any financial decision upon expected future income might be a tricky proposition. You’re essentially betting on your future income.
Let’s say you’re in law school or medical school. Or, perhaps you’re beginning any potentially well-paying profession. You know you’ll eventually be able to afford the dream house in the leafy suburb with a great school district. But, right now you come up short. At the same time, you want to take advantage of attractive selling prices while they last. Graduated mortgage payments can make it happen for you.
GPMs offer low initial monthly mortgage payments that gradually increase. Typically they increase each year for five to 10 years. Then, they level off at a fixed rate for the rest of the loan’s term. They’re designed for home buyers who might not otherwise qualify.
But, they must be confident their income will continue to increase over time. Like conventional mortgages, they’re usually for 15- or 30-year terms. A graduated payment mortgage also has a fixed interest rate, although a slightly higher one.