What is a graduated payment mortgage?

These mortgages offer fixed rates but variable monthly payments

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When looking for a home loan, there are typically two options that buyers choose: fixed-rate loans or adjustable-rate loans. But a third option that may be appealing to some borrowers is a hybrid of the two.

Graduated payment mortgages (GPMs) offer a fixed-rate loan with lower initial payments that increase over time. This allows borrowers who don’t qualify for a traditional home loan the ability to buy a home and afford the initial payments.

But GPMs are not the best option for many, so it’s important to review how they work, compare them to other loan types and see an example of how the payments are set up before choosing one.


Key insights

  • GPMs are fixed-rate loans with lower initial payments than conventional loans, but payments increase over time.
  • Most graduated payment loans are offered by the FHA, with five- or 10-year payment increase schedules.
  • GPMs may negatively amortize, meaning your loan balances actually go up each year before payments eventually rise to pay down your loan.
  • Some GPMs come with prepayment penalties for paying off the loan early or refinancing, which can cost money.

How graduated payment mortgages work

“Graduated payment loans (GPMs) are a type of mortgage loan that offers borrowers lower initial monthly payments that gradually increase over time,” said Chris McGuire, a licensed real estate broker and founder of Real Estate Exam Ninja. “This structure is designed to accommodate borrowers who expect their income to increase steadily in the future.”

The idea behind a GPM is to help first-time homebuyers and those who can’t afford a conventional loan purchase a home with lower payments (at first). And as the borrower’s income increases, the mortgage payment will also increase.

The Federal Housing Administration (FHA) typically offers GPMs and has payment increases over a five- or 10-year period. These mortgages are sometimes referred to as Section 245(a) mortgages.

The Department of Housing and Urban Development (HUD) sets the rate for GPM loans based on the going 30-year mortgage rate. The payment is lower for the first five or 10 years of the loan, then gradually increases and eventually stabilizes for the rest of the loan. The loan payment may increase by 2.5%, 5% or 7.5% per year on a five-year schedule or 2% to 3% on a 10-year schedule.

Some GPM loans may be negative amortization loans, meaning the overall loan balance increases even though you’re making mortgage payments. Eventually, the increased payments start paying down the principal of your mortgage, and all FHA-sponsored GPM loans are self-amortizing, meaning they are fully paid off at the end of the loan term.

» MORE: What is an FHA loan? Your guide to FHA mortgages

Graduated payment vs. adjustable-rate mortgage

Both graduated payment and adjustable-rate mortgages (ARMs) change your payment over time. But while GPMs are a fixed-rate loan product with a payment increase schedule, ARMs may raise or lower interest rates based on prevailing interest rates.

Graduated payment mortgages typically have a five- or 10-year payment increase schedule, with a small increase each year until the loan payment stabilizes. ARMs change rates based on the loan agreement.

For example, on a 5/1 ARM loan, the rate can adjust every year after an initial five-year, fixed-rate period ends. The rate on a 5/6 ARM can adjust every six months after the five-year loan period.

Example of a graduated payment mortgage

Here’s a quick example of what a five-year graduated payment plan with 5% annual payment increases could look like on a $300,000 mortgage at a 7% interest rate:

Source: DecisionAide Analytics

As you can see, the initial payments aren’t enough to fully cover the interest payments and cause the loan to increase in balance over the first two years of the loan. This is an example of negative amortization.

After year three, the balance starts to reduce, and by year six, the loan payment is now fixed for the remainder of the loan term.

When compared to a conventional 30-year fixed-rate mortgage, the monthly payment starts and ends at $1,995.91.

Pros and cons of a graduated payment mortgage

As mentioned, GPMs can help first-time homebuyers and those who can’t quite afford the payment of a standard mortgage. The payments start lower but increase over time. There are some advantages and disadvantages to these types of mortgages:

Pros

  • Lower initial payments
  • Same 30-year term as a conventional loan
  • Can help lower-income households qualify for a mortgage

Cons

  • May be in negative amortization for first few years
  • May come with a prepayment penalty
  • Payments end up being higher than traditional mortgage after increases

How to get a graduated payment mortgage

To apply for a graduated payment mortgage, you’ll first need to find a lender that offers it. Most lenders that offer FHA loans should have access to GPM loans. Once you find a lender that offers a GPM, you’ll apply for it just like any other mortgage.

You’ll need to submit personal and financial information to get preapproved for the mortgage. This may include submitting bank and other statements and proof of employment, as well as undergoing a credit check. You may also need to detail your current debt payments not on your credit report.

Once approved, you’ll complete the loan application process, which includes making an offer on a home, getting the offer accepted and performing due diligence on your home purchase. Once the loan is closed and you own the home, you’ll need to start making monthly mortgage payments to your lender.

Remember, the amount will increase every year, so expect a larger home payment each year, according to your GPM agreement. And if your homeowners insurance or property taxes also increase, you might have a much larger home payment each year.

Also, if you want to refinance your loan or get into a conventional mortgage, it’s important to know about any prepayment penalties your lender has. These penalties may be in place to protect the lender from you choosing to refinance soon after getting the mortgage.

» MORE: Mortgage lender vs. bank

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    FAQ

    Is a graduated payment the same as an ARM?

    No. A graduated payment is a fixed-rate mortgage with annual increasing payments for a set amount of time (usually five or 10 years). After the increases stop, you will have a fixed payment for the remainder of the mortgage. ARMs adjust your interest rate on a set schedule. The rate can go up or down based on market interest rates. This can lower or increase your payment for the entirety of the mortgage.

    How long is a graduated payment plan for a mortgage?

    Most graduated payment mortgages are 30-year loans that increase payments for five or 10 years. The FHA has a set payment increase schedule for GPMs, with payments increasing anywhere from 2% to 7.5% per year, depending on the loan.

    What is a growing equity mortgage?

    A growing equity mortgage is a home loan that gradually increases mortgage principal payments on a set schedule to help you pay off your home early. These loans may come with lower down payment requirements and are typically for first-time homebuyers who may not have the funds to close on a conventional mortgage. The FHA also offers a program for growing equity mortgages that increases payment between 1% and 5% per year, paying off 30-year mortgages within 22 years.

    What type of mortgage has the lowest rate?

    In most cases, government-backed mortgages (such as FHA or VA loans) offer the lowest interest rates, but it depends on your income, credit profile and other factors. While some fixed-rate loans offer low rates for borrowers with excellent credit, ARMs usually offer the best rates initially. This is because ARMs can increase interest rates over time, which may end up costing you more in the long run.

    Bottom line

    “Considering a graduated payment mortgage can be beneficial for borrowers who anticipate a steady rise in their income over the coming years,” McGuire said. “This mortgage option can provide initial affordability when purchasing a home or managing cash flow during the early years of a career.”

    But while the low payment may be enticing, it’s important to realize that the loan could cost you more in the long run due to negative amortization and higher payments. Plus, GPMs may come with prepayment penalties, costing you even more to refinance or pay off your loan early.

    As with any home loan, it’s best to talk with a qualified mortgage lender about your home loan options to find one that fits your situation best.


    Article sources
    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
    1. U.S. Department of Housing and Urban Development, “The Graduated Payment Mortgage Program (4240.2).” Accessed Feb. 24, 2024.
    2. U.S. Department of Housing and Urban Development, “4240.2 REV APPENDIX 1.” Accessed Feb. 24, 2024.
    3. Consumer Financial Protection Bureau, “Consumer Handbook on Adjustable-Rate Mortgages.” Accessed Feb. 24, 2024.
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