Here we're gonna talk about graduated payment mortgages which are sometimes abbreviated as GPM. So a graduated-payment mortgage is a mortgage in which the payments are going to gradually increase or step up over time. So for example in the first year of the mortgage that monthly payment might be $500 a month, the second year it might be $550, third-year it might be $600, and then at some point, it typically levels out, and let's say it becomes $650 to the ending or whatever their mortgage ends.
Example:
Let's walk through an example, let's say that you have a 30-year mortgage and the interest rate is 12% but here's the catch, it's a graduated-payment mortgage because payments are gonna increase by 7.5% annually for the first 5 years.
Now that's the mortgage payment is gonna increase not the interest rate. Let's take a look at how that would play out. So in the beginning you've got a balance of $60,000. I'll just call that "Year Zero", this is when you get the loan. So what happens is that if you were doing a regular mortgage, that would be required to amortize $617.17 but for whatever reason maybe you're having a hard time qualifying or your income isn't very high right now but you expected to be higher in the next few years you're gonna agree to this graduated-payment mortgage. And your payments actually only going to be $474.83 in the first period.
So every month you're paying this $474.83 instead of paying $617.17. The issue that creates is your loan balance will actually increase. You might seem weird and say "Hey this is weird that's actually called negative amortization (We'll write about it in a different article)." So negative amortization is just your loan balances increasing and the reason is that your payment isn't sufficient to cover all the interest that is incurring on your loan each month.
For example, let's take the $60,000 if the interest is 12% for one month, the interest alone would be $600 for month 1, but you're only paying $474.83. So that means that you are not even covering all the interest. So what is happening is that interest, that difference between the $600 and the $474.83 gets added to the loan balance and that's happening every month. So this loan balance is actually growing larger and larger whereas if you'd paid the $617.17 you would have had $17.17 that the first month going toward the principal but you're not paying down the principal yet.
Now you might say "Why do I want this?" Well, the thing is that you're saving if we look at the difference between $617.17 and the payment you're making of $474.83 you have savings of $142.34 per month in year 1. Now you're getting a larger loan balance but you're saying "Hey look I believe I'm willing to pay more next year." So ultimately year 6 to year 30 you're paying $681.67.
You have been paying $617.17 throughout the entire life of the loan instead what happens is you start at $474.83 and by year 6 you get to $681.67 and then you just keep that $681.67 for the remainder of the life along.
Pros and Cons of Graduated Payment Mortgages:
Pros:
- Lower payment in the first months.
- May able to pay off the debt faster.
- There is a possibility that your income may not increase that much.
- This is only for federal loans.
