The graduated payment mortgage is particularly beneficial to the young borrower. This type of loan was designed to help a borrower whose income was expected to increase after the purchase.
Before examining graduated payment mortgages, we should define the term amortization. When you amortize (pay off) a loan, you kill it. The phrase life of the loan is used as a synonym for the term of the loan. The word amortize has come to mean paying down the principal as well as paying the loan in full. If you are told that your loan will be amortized over thirty years, it means that if you make the required payments, you will pay the loan in full in thirty years.
The graduated payment mortgage starts off with a very low payment. The payment is lower than even the interest portion of the loan payment amount. This means that the amount you owe on your loan will actually increase, even though you are making your required payments. This is called negative amortization.
Each year, the amount you pay will increase to make up for the negative amortization. There are different rates of increase depending on your specific loan agreement, but a common increase is 7.5% per year for five years. At the end of five years, your payment will stay the same for the rest of the term. This stable payment will be higher than if you originally got a fixed rate loan.
The risk is obvious. You are counting on being in a better financial situation in the future so that you are able to make the increasing payment amounts. In the past, a better future financial position was taken as a given. For example, union contracts were always renewed with wage and benefit increases. In those cases, this type of loan carried little risk for a union member. Today, jobs are less secure and pay raises are even less secure.
The benefit with the graduated payment mortgage is that it may be easier to qualify. Since the mortgage expense part of qualifying is based on your initial monthly payment, you can see the advantage. Your initial monthly payment is even lower than an interest-only loan. However, this is a high-risk loan. You should be fairly certain that you will be able to meet the future increased payments. There is some relief to the risks associated with this loan. If you believe that you live in an area with rising housing prices, you may have some built-in protection. If you cannot afford the increased payment amount, you will be able to sell your property and have some money to relocate to something you can afford. Of course, if housing prices are rising, it will be more expensive for you to stay in the same area.