How Graduated Payment Mortgages (GPMs) Work

After four years of sharing a 600-square-foot studio apartment, you and your wife deserve a medal. The apartment has let you save on rent while you both work through grad school. But now that you have a baby on the way, there’s no way you can keep living here. If only your degree was going to arrive before your daughter.

Frank
Scott J. Ferrell/Congressional Quarterly/Getty Images
U.S. Senator Barney Frank (D-Mass.) is among the legislators currently working to reduce the number of foreclosures.

A graduated-payment mortgage (GPM) might be able to help you. Like adjustable rate mortgages and interest-only loans, GPMs were created to make home ownership possible for people to whom traditional types of financing are out of reach. As with those other types, there’s a trade-off for being able to purchase the house of your dreams.

Say that you are in law school or medical school, or you are about to embark on any potentially well-paying profession. You know that eventually you’ll have the kind of earning power to afford that four-bedroom colonial with two-car garage in the leafy suburb with good schools, 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 payments that gradually increase each year for five to 10 years until they level off at a fixed rate for the rest of the term. They’re designed for home buyers who might not otherwise qualify for the loan they need but who are confident their income will steadily increase over time. Like conventional mortgages, they’re usually for 15- or 30-year terms, and they also have a fixed interest rate, although a slightly higher one.

Read on to see what your payments would look like under various GPM plans in comparison to a conventional loan.

Restrictions on GPMs
Owners must occupy the home as their principal residence; real estate investors need not apply. They also must be purchasing a single-unit dwelling. Beyond that, there are few restrictions on who can take out this type of mortgage, although the loans were designed for low- to moderate-income buyers who expect income appreciation. This type of mortgage is also known as a Section 245 loan.

What Are Graduated Payment Mortgages?

Remember the maxim "pay now or pay later"? This is the basic idea behind GPMs. Basically, they allow you to buy more house than you can afford -- for now. While your payments during the first few years could be as much as several hundred dollars lower than they would be if you took out a 30-year fixed-rate mortgage, they will ultimately be higher. It also takes you longer to build equity in the home, and you will end up paying more interest in the long run with a GPM.

Padlocked gate
Justin Sullivan/Getty Images
In spring 2008, Stockton, California, led the nation in foreclosures, with one of every 30 properties being repossessed. If you know your income will go up in a few years, graduated mortgage payments can help you
avoid this fate.


You can get a GPM from any lending institution. You can choose from among several plan types, which typically involve annual payment increases of 2.5 percent, 5 percent or 7.5 percent during the first five years, or 2 percent-3 percent increases over 10 years. The higher the annual increase, the lower the early payments are. If you choose the 7.5 percent option, you'll have lower initial payments but ultimately end up with a higher payment.

On a $200,000 loan with a 30-year fixed rate of 6.5 percent, your monthly payment of principal and interest would be set at $1,264 for the life of the loan. Let's look at what happens if you take out a GPM loan for the same amount and same interest rate, comparing the 2.5 percent and 7.5 percent plans:

Year

2.5 percent increase

7.5 percent increase

1

$1,144

$940

2

$1,173

$1,011

3

$1,203

$1,087

4

$1,232

$1,168

5

$1,263

$1,256




Remaining Payments

$1,295

$1,350

As you can see, while the 2.5 percent plan starts off with monthly payments $200 higher than the 7.5 percent plan, annual increases are much smaller (about $30) and payments level off at a lower amount.

On the next page, find out what you should know before taking out a GPM and why they aren't for everyone.

GPM versus ARM: The Showdown
Don't confuse GPMs with ARMs (Adjustable Rate Mortgages). With a GPM, there are no surprises; you know exactly what you're in for. GPMs rise at a predetermined rate, unlike ARMs, which can fluctuate wildly with rising or falling interest rates. Remember that it's your payment that's increasing, not your interest rate.

Advantages and Disadvantages of GPMs

It's important to understand that GPMs experience negative amortization in the early years of the loan. This is when the monthly payment is not enough to cover the interest on the loan, so the unpaid interest gets added to the mortgage balance. In other words, instead of paying down your principal a little more each year as is the case with most mortgages, you're actually increasing your principal balance for the first five or 10 years, depending on the type of plan you choose. At the end of that period, you owe more than you did when you took out the loan. This all stops once your loan levels off at its permanent fixed rate. Then you begin paying down the principal.

With the plans compared on the previous page, the 7.5 percent plan would carry the greatest negative amortization, because the borrower enjoys the lowest payments.

Reduced sale sign
Joe Raedle/Getty Images
In the midst of market turmoil and recession fears, many home prices have fallen in 2008. If you're willing to accept the additional risk, a GPM could make it easier for you to get a bargain on the house you want.


Although undoubtedly less risky than adjustable-rate mortgages (ARMs), GPMs can still be something of a gamble. If your income doesn't grow as anticipated, if you or your spouse loses a job, if you divorce or if you face other unexpected financial challenges, you'll find yourself staring down the barrel of rising house payments. What's more, the amount you owe the lender has grown while you have gained little equity in the home, which could become a nasty problem in the event of stagnant or declining real estate values.

Also, like other mortgage loans, GPMs may have a prepayment penalty if the balance is paid off early.

So is a GPM right for you? If you're in an occupation that's likely to have a salary increase as the years go on, then a GPM might work for you. Some of these include medical professionals, lawyers, engineers, accountants and IT professionals. However, if you're industry is less secure, then you should proceed with caution. Perhaps if you're an actor, artist, writer, day trader or sales person you may want to weigh other options. GPMs are also not good for self-employed individuals, unless your business is very successful and expected to grow in profitability.

The bottom line: Know what you're getting in to, weigh all your options, and get good advice. And it never hurts to be well-informed about such a big decision. Take a look at the links below to find out more.

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More Great Links

Sources

  • City Town Info: www.citytowninfo.com/mortgage-articles/specialty-mortgages/graduated-
    payment-mortgage
  • Jack M. Guttentag, professor of finance emeritus, Wharton School: www.mtgprofessor.com/a percent20- percent20other percent20mortgage percent20types/should_you_go_with_a_gpm.htm
  • U.S. Dept. of Housing & Urban Development (HUD): www.hud.gov/offices/hsg/sfh/gpm/gpm_calc.cfm
  • HUD. www.hud.gov/offices/hsg/sfh/ins/245--dft.cfm
  • FHA.com: www.fha.com/graduated_payment.cfm
  • Investopedia: www.investopedia.com/terms/g/graduatedpaymentmortgage.asp
  • Mortgage Lenders Financial Network: www.loanexpo.com/gpm.htm
  • MortgageCalc.com: www.mortgage-calc.com/index.html
  • NexTag Comparison Shopping: www.nextag.com/home-mortgage/0/What-is-a-Graduated-Payment-
    Mortgage.html
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