What Is a Graduated-Payment Mortgage?

Graduated-Payment Mortgages Explained

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Graduated-payment mortgages (GPMs) are a type of loan that replaces the typical structure of an equal payment each month with an increasing payment over time. By increasing the payment by 2% to 7.5% each year for five or 10 years, these loan products allow individuals and families to qualify for a lower mortgage payment initially. The payments go up predictably, allowing you to plan over time to make the growing payments. After a few years, these mortgages level off and the payment stays at a single level for the rest of the term.

GPMs aim to create more opportunities for first-time homebuyers and low-income homeowners. They are secured through the federal government as FHA loans. The benefits of these mortgages also come with drawbacks. The loan is more expensive overall than it would be with a standard mortgage. Payments may become unaffordable if you suffer a financial hardship, such as unemployment.

Learn more about how graduated-payment mortgages work and whether they’re the right option for you.

Definition and Examples of Graduated-Payment Mortgages

Graduated-payment mortgages are a kind of loan offered through the Federal Housing Administration (FHA). These loans start with a smaller payment than you would often have during the first year of your mortgage. After the first year, the payment is structured to grow each year, usually somewhere between 2% and 7.5%, for the first few years of the loan.

Qualifying for a home loan when you have a low income can be a challenge. A graduated-payment mortgage can be a good option if you can’t afford payments for a conventional loan but expect your income to grow in the next few years. HUD developed the program in the 1970s to remove barriers to homebuying for lower-income families.

For instance, if a regular home loan would cost you $1,200 a month and your income can’t support that cost right now, you could look at a graduated-payment mortgage with a five-year term. This might bring your first down payment to, say, $800 a month for the first year. After that, your payment would go up by 7.5%. The payment would increase each year for five years before leveling out—and staying the same until you pay off the house.

  • Acronym: GPM

Some loan plans offer different term lengths. The rate at which your loan increases depends on which plan you choose.

How Does a Graduated-Payment Mortgage Work?

Graduated-payment mortgages keep early mortgage payments low by deferring interest. This means you pay less than the total amount of interest owed in the early months or even years of the loan. That interest is added to the loan’s principal and is paid off later. This loan structure means you’ll pay more interest in the long run in exchange for more affordable payments early on.

To qualify for an FHA-insured graduated-payment mortgage, you’ll need to work with an approved HUD lender who can issue these government-backed loans. Not all lenders can offer this type of mortgage, and some may not offer it even if they are HUD approved.

There are five graduated-payment mortgage plans. The first three have a five-year term and increase each year by 2.5%, 5%, or 7.5%. The other two have a ten-year term and increase by either 2% or 3%.

One downside of a GPM loan is that it may have a period of negative amortization. This occurs when unpaid interest is added to the balance of your loan. This might mean the amount you owe on the mortgage is higher than the market value of your home (often called being “underwater”).

Getting through this period and beginning to build equity in the home is critical. That way, if you have to sell your home, you’d be able to pay the full balance due on your mortgage. Otherwise, you’ll still be in debt to the lender even after the house sells.

Do I Need a Graduated-Payment Mortgage?

Many first-time homebuyers and low-income homebuyers consider FHA loans. These loans allow you to finance a big portion of your mortgage using as little as 3.5% for your down payment. If the loans are GPMs, they also have an attractive low payment to start, which will rise over time.

You can make a GPM a less risky proposal by planning for the higher payments that are coming. Create a separate savings account or investment account where you can save for future loan payments. Whenever you experience a windfall or a pay raise, use it to start saving money in that fund. If you ever cannot afford the growing payments, you can use the savings account to pay for the increasing mortgage payments until you’re back on your feet.

If you can wait, though, and save a larger down payment or grow your income before you apply for a mortgage, this might be a smart option. A conventional loan will often be less expensive because you’ll pay less interest over the life of the loan. It’s worth considering both options as well as the benefits of having your property now versus later.

Alternatives to Graduated-Payment Mortgages

If you know you won’t be able to afford the payments on a conventional loan for the property you are considering, you have two main alternatives to GPMs. You can delay buying a home while you increase your savings and income. Or you can choose a less expensive property and qualify for a different type of loan.

Among deferred interest mortgages, however, there are other structures, including a loan with a balloon payment. This is a mortgage loan that allows a lower monthly payment, but you will have to pay a large one-time payment later. This payment may come due after a few years or at the end of the loan. You’ll need to save up money to pay the balloon payment, which might be a challenge, depending on your income and your ability to save.

Once you’ve found potential lenders, talk to each one about the types of FHA and conventional loan products for which you can qualify. The fees and penalties that you could owe will vary with each type of loan. Know the pros and cons of each choice before you commit to a mortgage.

Key Takeaways

  • Graduated-payment mortgages are mortgages with a lower initial payment that increases each year for five to 10 years.
  • These types of mortgages allow first-time and low-income homebuyers to qualify for an affordable mortgage while they grow their income.
  • If you don’t have a plan for budgeting as the payments increase, graduated-payment mortgages can become a source of financial stress.
  • GPMs often cost more in interest than comparable conventional loans.