Graduated payment mortgages are beneficial to many types of homebuyers. These are fixed-rate mortgages, and their main aim is to help homeowners start with a low monthly payment. These mortgages are suitable for those homebuyers who don’t have much income yet but want to purchase a home. By increasing payments, these mortgages allow the borrower to qualify for a lower initial payment. The graduated payment mortgages are best suited for low-income and first-time homebuyers. They are mostly issued by the federal government or government-backed organizations, for example, the FHA. In this post, you’ll learn how graduated payment mortgages work and who should get these mortgages.
What Is a Graduated Payment Mortgage?
A graduated payment mortgage is a home loan with monthly payments starting out at one amount and then, after a while, payments that increase gradually over time.
A graduated payment mortgage is a home loan with both fixed and adjustable rates. Most mortgages are either fixed-rate or adjustable-rate, but this is an exception. A graduated payment mortgage has fixed and variable rates and graduated payments. The mortgages are self-amortizing and allow the borrowers to make lower initial payments that increase over time.
These mortgages are more costly than conventional ones, and homeowners might find it difficult to repay the loans if their income doesn’t rise over time. Thus, these mortgages are more suitable for those homebuyers whose income is expected to grow in the future; otherwise, there’s a chance of defaulting on the loan and losing the property.
How Graduated Payment Mortgages Work?
Graduated payment mortgages are self-amortizing, which means that the balance is completely paid off till the loan matures. The mortgage has a very low initial interest rate which makes the initial monthly payments low too. A graduated payment mortgage may or may not be a negative amortization loan. If the monthly payments are insufficient to cover the interest, negative amortization will occur.
The payments increase by a different percentage each year for a few years, and then the percentage gets fixed for the remaining years. This tells how these mortgages work as variable as well as fixed-rate mortgages. These mortgages are primarily available for 15 and 30 years. For instance, for a 30-year mortgage, the monthly payments will increase by 5% for the first ten years, then it will rise to 10% per year for the remaining 20 years and remain fixed throughout. The borrower will have to pay this increased monthly rate for 20 years.
How are Graduated Payment Mortgages Calculated?
Graduated Payment Mortgages are calculated using the mortgage loan amount, the interest rate, the number of graduations applied, and the annual graduation rate. Once these terms are known, the monthly payments for a graduated-payment mortgage can be calculated. The mortgage loan amount is the amount the borrower will receive as a home loan along with a predetermined interest rate. The following are the explanation of other terms:
Number of Annual Graduations
The number of annual graduations is usually between 2 and 5. The number of annual graduations refers to the times the annual graduation rate will be applied to the payment. For example, if the annual graduation rate is 2, the yearly payment will be different for years 1 and 2, and then it will be fixed for the remaining years.
Annual Graduation Rate
The annual graduation rate can be anywhere between 5% and 12%. This is the rate at which the payments will increase yearly until the total payment amount is reached by the end of the term.
Benefits of Graduated Payment Mortgages
The biggest benefit of graduated payment mortgages includes low upfront costs. The main idea of these mortgages is that they start with low payments that grow gradually over time and are quite affordable. Besides that, these mortgages are easier to qualify for. Since these mortgages have low initial payments, lenders easily approve borrowers based on their incomes. Since the requirements are less-strict for buying homes, the borrowers can easily qualify for a large home with lower payments.
Drawbacks of Graduated Payment Mortgages
Graduated payment mortgages are complicated because of varying factors. Negative amortization can also occur if the payments are less than the interest during the initial period. This means the mortgage balance will increase quickly, and the borrower might have a mortgage balance of more than the home’s worth. Lastly, these mortgages rely on future income growth, which is risky.
Negative Amortization in Graduated Payment Mortgages
Depending on the interest rate, graduated payment mortgages can negatively amortize too. Negative amortization occurs when the loan balance increases instead of decreasing. This happens when the initial monthly payments are lower than the interest payments. Suppose a person gets a graduated-payment mortgage of $150,000, a 30-year term at a 6% fixed interest rate. The monthly payment increases by 5% every year, and since the number of annual graduations is 5, this rate increases for 5 years. In year 1, the interest payment is higher than the monthly payment, but in year 2, it decreases. This causes negative amortization, and it can take place for several years. Negative amortization is risky because it keeps on adding more to the outstanding mortgage. This also causes the payments to increase because of the increased principal.
Graduated Payment Mortgage Vs. Adjustable-Rate Mortgage
Monthly payments change in both graduated payment mortgages and adjustable rate mortgages. However, how these payments change is quite different. In adjustable-rate mortgages, the payments vary because of the adjustable rates. The interest rate is fixed in adjustable-rate mortgages for a few initial years and then is adjusted according to the market rate. The interest rate can be increased or decreased, and the borrower can’t predict whether their payments will increase or decrease.
On the other, with a graduated-payment mortgage, the borrower knows the changes that will occur in the payments. This is because the interest rate is fixed throughout the term, and the payments increase because of the annual graduation rate that is applied.
Graduated Payment Mortgage Examples
Example: Suppose Bob purchases a property worth $315,000 using a Graduated payment mortgage. The following are the details of the graduated payment mortgage he obtained:
- Property value: $315,000
- Mortgage amount: $275,000
- Term: 30 years
- Interest rate: 4%
- Number of annual graduations: 2
- Annual graduation rate: 5%
The above details show that the graduated payment mortgage has 2 annual graduations and an annual graduation rate of 5%. The yearly payments for this mortgage will be as follows:
- Year 1: $1200.17
- Year 2: $1260.18
- Year 3 – 30: $1323.18
Since the number of annual graduations is 2, the payments change in the first and second years and remain fixed until the end of the term. The payments are low during the first two years, then they increase and remain fixed for the remaining years.
Frequently Asked Questions
Who Should Get a Graduated Payment Mortgage?
Graduated payment mortgages are suitable for those borrowers who aren’t able to make high monthly payments. Instead, these borrowers know their salaries will rise in the coming years, but currently, it is very low, and they can’t afford a mortgage.
For instance, a fresh graduate who is an engineer or doctor. Maybe they just found a job and are looking to buy a home. Since they recently graduated college, they more than likely have no assets, but they know their income will rise gradually because of their expertise. A graduated payment mortgage is a good option for such professionals and specialized degree holders with an initial low income, but an expected rise in the future.
What are the Risks Associated with a Graduated Payment Mortgage?
Graduated Payment Mortgages are risky. The main risk is that if the borrower’s income doesn’t rise as expected, it would be impossible to repay the loan with higher monthly payments than before. These mortgages are not very affordable after a few years; thus, the borrower must do calculations and evaluate whether they will be able to afford the mortgage in the future.
During the mortgage term, the borrower will be paying more interest. Basing any financial decision on expected income is risky because nothing can be accurately predicted. On the other hand, a mortgage with fixed monthly payments is more predictable because the borrower knows what they will keep paying every month in the future.
What are the Alternatives to Graduated Payment Mortgages?
If the borrower is currently unable to afford the monthly payments of a conventional mortgage and a graduated-payment mortgage is too risky, they must consider other alternatives. For instance, they can consider a balloon mortgage in which the monthly payments are low throughout the term. This loan doesn’t amortize fully till the end of the term because of low monthly payments, and the borrower has to pay a lump sum (balloon payment) at the end of the term to pay off the loan.
What are the Requirements for a Graduated Payment Mortgage?
The following are the requirements for a graduated-payment mortgage:
- Minimum 3.5% down payment
- Property type includes single-unit, primary residence
- FHA mortgage insurance premiums
Where to Get a Graduated Payment Mortgage?
Graduated payment mortgages are offered through the FHA (Federal Housing Administration). These mortgages are FHA insured and are easy to qualify for. FHA offers GPMs for 15 and 30-year mortgage terms.
What to Know for the Real Estate Exam
Remember, a graduated payment mortgage is a home loan with monthly payments starting out at one amount and then, after a while, payments that increase gradually over time. The payments grow yearly by 2% to 7.5% for the first few years of the mortgage. These mortgages have fixed rates, but varying payments and are suitable for those who believe their income will rise in the upcoming years. Graduated payment mortgages are complicated, but I hope this post makes them easier to understand. If you’re preparing for a real estate exam, go through these easy-to-learn real estate terms.