How Growing Equity Mortgages (GEMs) Work

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That new house for sale down the street seems perfect -- big backyard, the right number of bedrooms and a great location. You expect a promotion in six months, but you don't have the money to pay for that home's mortgage now, and it may be sold before your new salary kicks in. A growing equity mortgage (GEM) may be the perfect answer for your situation.

A GEM is an alternative mortgage where payments increase over the life of the loan. The interest rate is fixed and the homeowner's monthly payments increase at a fixed rate -- either monthly or annually. This payment increase is applied toward the loan principal instead of the interest, as it would be in a graduated mortgage payment. This allows the mortgage to be paid off at a much quicker rate, usually in just 15 years [source: CityTownInfo].

A GEM has lower up-front payments and costs, so it's ideal for young families or first-time buyers who just launched careers and savings. Those anticipating higher future incomes are best-suited for a GEM. Payments start out small and gradually increase. This builds equity quicker so that a 30-year mortgage can be paid off in half the time with a GEM versus a traditional mortgage.

Half the time…so why isn't everyone doing this? Keep reading to find out how a GEM works, and when it's not such a great idea.

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What Is a Growing Equity Mortgage (GEM)?

Prospective homebuyers can apply for many different types of mortgages. It's important to review all options before choosing a mortgage. Those who don't have much income now but expect their monthly income to increase may want to consider a growing equity
Prospective homebuyers can apply for many different types of mortgages. It's important to review all options before choosing a mortgage. Those who don't have much income now but expect their monthly income to increase may want to consider a growing equity
Jeff J. Mitchell/Getty Images

Paying off a mortgage in half the time seems like a good deal, but maybe it's too good to be true. How exactly does a growing equity mortgage work? A GEM has a fixed interest rate. This interest rate is often lower than the current market rate, because payments will increase over time. The increase occurs gradually, either monthly or annually. It's usually based on an index like the U.S. Commerce Department Index, or on a schedule that you and the mortgage company have agreed upon at the start [source: Utopia Mortgage & Real Estate].

Because the payments increase so often, the borrower is paying such high amounts that the interest doesn't increase. No negative amortization is allowed. Negative amortization is when the amount of money owed increases because the monthly payment is so small that it doesn't cover the interest due. It typically occurs when interest is high and payments are low. You may see a similar situation when someone pays only the minimum on a high-interest credit card that carries a large balance. But GEMs don't have negative amortization on account of the high payments and low interest rates, so your payments go toward paying down more of the principal of the loan -- not just the interest. Coupled with the continually larger payments, a GEM allows a 30-year mortgage to be paid off in 15 to 20 years -- sometimes even less [source: National Association of Home Builders].

As we learned earlier, people who don't have large amounts of money saved up for a down payment -- like young families or first-time homebuyers -- can pay off a mortgage more quickly with a GEM. However, the entire plan is contingent upon the fact that a person will be able to afford a higher payment in the future. Just being a first-time homebuyer doesn't automatically make someone a good candidate for a GEM. If that first-timer is already settled into a career with few promotions down the line, he probably won't be able to make the increased payments because his income will stay about the same.

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Meanwhile, someone who has just graduated from school and landed a new career is probably not making a lot of money yet. But she may be working at a company with a lot of room to grow. Maybe she's on a career track leading to a high-paying job. With the anticipated increased salary, this prospective homebuyer is an ideal candidate for a GEM. Someone considering a GEM should be sure that he or she will earn more money soon to afford the increasing mortgage payments on a GEM.

But life doesn't always happen as planned. What happens if your income doesn't increase as you expected or if you suddenly lose your job? GEMs have their downsides, so read on to find out the advantages and disadvantages of a GEM.

Advantages and Disadvantages with Growing Equity Mortgages (GEMs)

As the number of foreclosures mounts due to the downturn in the economy, real estate disposition companies must deal with homes that have been foreclosed on and are in need of repair.
As the number of foreclosures mounts due to the downturn in the economy, real estate disposition companies must deal with homes that have been foreclosed on and are in need of repair.
Joe Raedle/Getty Images

Just as the name says, growing equity mortgages or GEMs are beneficial because they grow equity quicker than traditional mortgages. A homeowner may even pay off her mortgages in half the time, and she'll pay significantly less interest because of the higher payments and decreased loan length.

GEMs also have the advantage over graduated-payment mortgages or GPMs. GEMs and GPMs both start with lower payments and increase. GPM payments are so small that they generally don't even cover all of the interest that's owed each month. GPM borrowers are building more debt, which leads to negative amortization. A GEM's lack of negative amortization makes it much more attractive in the long term -- if a borrower can afford it.

Between the shortened term and the total money saved, it seems like more people should be using a GEM. There is really only one drawback to a GEM, but it's a big one. With any mortgage there is always the possibility that sometime in the future the borrower won't be able to make the payments. Maybe the borrower loses a job or changes careers, and can no longer afford to pay the mortgage. With a GEM, this threat is compounded. Not only does the borrower have to keep making payments, but the payments keep getting larger. Being unable to keep up could cause a borrower to end up in foreclosure.

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Not only does someone have to continue making money, but they need to continue making more money. A GEM borrower's earnings must outpace the cost of living. His or her job needs to continue paying more through raises and promotions. Even if the borrower's salary increases, it may not be enough to keep up with the payments. Or, if the GEM monthly payment increases are based on the U.S. Commerce Department Index, the index could suddenly rise more drastically than anticipated. And if the borrower can't keep up with those payments, he or she could lose the house. GEMs can be beneficial, but borrowers should consider the risks.

For more information on mortgages, visit the links on the next page.

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Sources:

  • CityTownInfo. "Growing Equity Mortgage." http://www.citytowninfo.com/mortgage-articles/specialty-mortgages/growing-equity-mortgage (Accessed 5/21/08)
  • FHA Mortgage. "FHA Growing Equity Mortgage." http://www.fhamortgage.com/fha-growing-equity.cfm (Accessed 5/21/08)
  • iLoan Financial. "Growing Equity Mortgage." http://www.iloanfinancial.com/growing-equity-mortgage.html (Accessed 5/21/08)
  • National Association of Home Builders. "Home Buyer's Dictionary." http://www.nahb.org/generic.aspx?genericContentID=351 (Accessed 5/21/08)
  • Procter, Brenda. "Housing Finance Basics: Finding the Right Home Mortgage." MissouriFamilies.org. http://missourifamilies.org/features/financearticles/mortgage.htm (Accessed 5/21/08)
  • Steinmetz, Thomas C. "The Mortgage Kit." Fifth Edition. Dearborn Trade Publishing. New York: 2002.
  • U.S. Department of Housing and Urban Development. "Growing Equity Mortgage Insurance (Section 245(a))." http://www.hud.gov/offices/hsg/sfh/ins/245a--df.cfm (Accessed 5/21/08)
  • Utopia Mortgage & Real Estate. "A Possible Gem for Home Mortgage Seekers - the Growing Equity Mortgage." http://www.bestsandiegorealtors.com/growingequitymortgage.htm (Accessed 5/21/08)