'Graduated Payment Mortgage (GPM)' is explained in detail and with examples in the Real Estate edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
A graduated payment mortgage is a special type of home mortgage where payments are low initially and go up over the term of the loan. These are still considered to be a type of fixed rate mortgages as the interest rates are set and pre-determined even when the payments rise.
The low upfront payment helps financial institutions to qualify the borrowers. Banks only have to take into account the original low rate to approve them. This is why the GPMs assist those who otherwise would not be able to get qualified using the normal FRM fixed rate mortgage. This aids a great number of potential home buyers who might not be able to get qualified to purchase a home. It is best for younger or newer homeowners. Their levels of income should rise with time. This helps them to make the increasing mortgage payments.
The payments rise every year with a graduated payment mortgage until the entire amount has been repaid. The amount that they increase varies from one contract to the next. Typically the payments rises between 7% and 12% each year from the original base amount.
There is a danger with these types of products. If the young home buyers do not see their income rise consistently and significantly enough, the increasing payments on the home will take a greater share of their take home pay every year. Eventually, they may not be able to afford the payments if their salaries do not rise sufficiently.
The original payment for these graduated payment mortgages is not enough to cover the loan’s interest. The difference between what is covered and what is not is called negative amortization. This amount adds on to the loan balance with every payment. It takes years for the rising payments to overcome this increase in the loan balance. Lenders do not like the fact that the balance goes up above the initial amount. Because of this they charge greater rates for these types of loans than they do for standard fixed rate mortgages.
The trade-off with a graduated payment mortgage is the larger payment that continues to grow for several years. This generally does not reach its peak level until five years have passed. The higher payment will then stay fixed for the rest of the mortgage term. This is the price to pay for a low upfront payment that a borrower can be approved for and can afford.
There are other kinds of graduated payment mortgages on the market. These alternatives provide varying rates of payment rises for different amounts of time. In one example, homeowners can get a gradually rising rate of 3% per year for ten years rather than pay more than 7% each year for 5 years. These alternative GPMs require a higher upfront payment amount and can also lead to a larger final payment. Because the initial payment is higher, the negative amortization will be less. This will cause the peak loan balance to be smaller.
GPMs are not unique in mortgages that have payments which increase. There are also fixed rate mortgages called temporary buy downs. These come with lower upfront payments during the loan’s early years. The advantage to these is that the loan does not incur negative amortization.
Temporary buy downs only work if someone pays for the buy down account. The financial institution takes money from this supplemental account to cover the lower payments in the first two years. This way the lender receives identical payments for the entire life of the loan. Either the home seller or the buyer has to supply the money for the supplemental account.