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Graduated-Payment Mortgage

A graduated-payment mortgage (GPM) is designed to be more affordable in the early years than the traditional mortgage. Its monthly payments start low and increase by a fixed percentage every year for five years. (Note: Not all lenders offer GPMs, especially when overall rates are generally low.)

The example, Figure 4.6, is a $100,000 graduated-payment mortgage at 8.75 percent. The starting monthly payment is $593.45 compared to $733.77 for a traditional mortgage. Its payment increases by 7.5 percent every year until it reaches $851.97 in the sixth year. From there on, it stays the same until paid off in 30 years.

The graduated-payment mortgage's amortization chart (see Figure 4.7) looks similar to the traditional loan's amortization chart, but it is different. For the first five years, the remaining loan balance goes up slightly instead of down like the traditional loan. This

FIGURE 4.6 Example of Graduated Payments

Example of Graduated Payments

is called negative amortization. Negative amortization (see Figure 4.8) occurs when your monthly payment is too small to cover the interest due your lender, so the lender adds the interest shortfall to your loan balance.

The outstanding principal balance of this graduated-payment mortgage reaches a maximum $104,050 at the end of the fifth year before starting back down again. Negative amortization is not inherently bad. It is simply a way for you to borrow more money so that you can buy the home that you want.

Advantages. The main advantage of the graduated-payment mortgage is affordability. Because of its low starting payments, you can qualify for a larger loan with less income.

In the example in Figure 4.9, you could qualify for a $100,000 loan with approximately 13 percent less income. This mortgage form is ideally suited for young homebuyers whose income will rise through raises and promotions to meet the GPM's rising monthly payments.

FIGURE 4.7 Amortization Chart of a Sample Graduated-Payment Mortgage

Amortization Chart of a Sample Graduated-Payment Mortgage

FIGURE 4.8 Question: With Negative Amortization, What Happens When Your Monthly Payments Are Too Small to Cover the Interest Due?

Question: With Negative Amortization, What Happens When Your Monthly Payments Are Too Small to Cover the Interest Due?

FIGURE 4.9 Comparison of a Traditional and a Graduated-Payment Mortgage (GPM): Approximate Income Required to Qualify for a $100,000 Loan

Comparison of a Traditional and a Graduated-Payment Mortgage (GPM): Approximate Income Required to Qualify for a $100,000 Loan

Disadvantages. First, lenders charge a slightly higher interest rate for GPMs. The rate for a graduated-payment mortgage is typically 0.75 percent to 1 percent higher than for a traditional mortgage.

Second, lenders usually require at least a 10-percent down payment with a GPM, compared to a minimum of 5 percent or less with a traditional mortgage.

Third, negative amortization, although not usually a problem, can be one under certain economic conditions. If home values go down in your area, a GPM's loan balance may become larger than the home's reduced value. This also can happen with a 5-percent down payment loan. The real problem is not negative amortization, but the local economy.

 
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