If you aren't familiar with a graduated payment mortgage (GPM), the concept can seem rather confusing. Before you visit a lender, take a look at this article which offers an overview of graduated payment mortgages.

A graduated payment mortgage, or GPM as it is sometimes called, is an alternative to a conventional mortgage. With a graduated payment mortgage, the borrower's payment is low in the initial years of the loan, but rises gradually throughout the term.

GPMs are becoming increasingly popular as lenders search for creative ways to qualify borrowers for a loan. Many borrowers who would not be eligible for a conventional mortgage are eligible for a graduated payment mortgage, because only the initial payment is used to qualify the borrower.

For example, the required monthly payment for a conventional 30 year mortgage loan with a fixed interest rate of 7.5 percent is $1,748.04.

For a 30 year graduated payment mortgage, with an interest rate of 7.5 percent, the initial required monthly payment is only $1,308.73-$439.31 less per month than the fixed rate mortgage payment, making it much easier for the borrower to qualify.

Of course, the $1,308.73 is only the initial payment; the payments will rise later on. In this example, the payment on the GPM will rise for 5 consecutive years at a rate of 7.5 percent. Future payments will look like this:

Year

Monthly Payment

One

$1,308.73

Two

$1,406.88

Three

$1,512.40

Four

$1,625.83

Five

$1,747.76

Six thru Thirty

$1,878.85

As you can see from the chart above, by year five, the borrower's payment using a graduated payment mortgage is the same as it would be in year one through year thirty with a conventional mortgage.

It should be noted, however, that not every graduated payment mortgage will have a payment increase for a period of 5 years at a rate of 7.5 percent. Different GPMs have different rates and periods. Some loans may have a 3.5 percent graduation rate over a period of 10 years or a 5 percent graduation rate over a period of 7 years.

No matter what the rate or period is, the initial payment is always lower, and payments later in the term are always higher. There is also one other thing that every graduated payment mortgage has in common: negative amortization.

Because payments are so low during the initial period, they are not enough to cover the required interest payments, let alone the principal. The difference that is not paid is added to the balance of the loan. In other words, even though the borrower is making the required monthly payment, they are not paying enough to reduce the principal. This is known as negative amortization.

A loan with a negative amortization feature can be compared to a credit card. As long as you make only the minimum payment required, you keep racking up interest charges. If the balance owed is rather large, you may never get it paid off.

A Graduated Payment Mortgage vs. a Conventional Mortgage

The following chart illustrates how much money you would still owe in interest and principal, and in turn on the balance, at the end of year 1, year 5, year 10, year 20, and year 30 after making only the minimum required payment on a graduated payment mortgage. To keep things simple, we will use the same numbers from the example above ($250,000 borrowed on a 30 year graduated payment mortgage, with a 7.5 percent interest rate, and a 7.5 percent payment increase for 5 years.

Year

Total Payments

Loan Balance

One

$15,704.76

$253,152.13

Five

$91,219.20

$254,243.81

Ten

$203,950.20

$233,223.54

Twenty

$429,412.20

$158,278.79

Thirty

$654,864.76

$0.00

Glancing at the chart above, you may be wondering how the loan balance could have increased beyond the $250,000 that was originally borrowed. The reason for this is because for the first three years, there was no money paid on the principal-it all went to interest. Even then, it was not enough to cover the required interest payments, thus adding more and more to the balance.

At the end of the 30 year term, the borrower who took out this mortgage would have paid $654,864.76 to borrow $250,000. If the same borrower had qualified for a conventional mortgage with an interest rate of 7.5 percent, the total amount paid at the end of 30 years would have been $629,294.40-a difference of $25,570.36.

Who Should Consider a Graduated Payment Mortgage?

Looking at numbers alone, it would seem that it only makes sense for a borrower to choose the conventional mortgage. After all, it would save a total of $25,570.36 over a 30 year period. But, if a borrower can not qualify for a conventional mortgage, a graduated payment mortgage would seem attractive, as it would give the borrower more buying power right from the start. It may also be a good mortgage loan option for an investor who is looking to turn a property quickly.

There is a definite disadvantage to using a graduated payment mortgage though. As demonstrated in the example above, it takes some time before the balance is knocked down. After 74 months (6.16 years), the borrower in this example would have spent $117,523.10 and would still owe $250,017.19-just a few dollars over the amount originally borrowed.

If the borrower decided to sell, they would need to get $367,540.24 for the home to pay off the balance and recoup the investment made in mortgage payments. In housing markets where homes appreciate quickly, this may not be a problem. But if home values in the area did not increase that rapidly, or worse, decreased, the borrower would be hard pressed to get much more than they originally paid for the house.

This is why it is a good idea to consider your financial goals, the amount of time you plan to stay in a home (the average is five years), and the amount of money you can reasonably afford every month before taking out a graduated payment mortgage.

It is also a good idea to investigate the different GPMs that are available. Remember, different interest rates and payment increases may apply. It may also be possible to get an ARM that works like a GPM.

A competent lending professional will be able to help you evaluate all of your options and crunch the numbers. You can also seek out one of the graduated payment mortgage calculators that can be found online and compare the results you get with results from other fixed rate mortgage calculators and adjustable rate mortgage calculators.