There are several options for financing your first investment property. Mortgages are prevalent in real estate financing,and there are many types to choose from, depending on your needs and current situation.
In this post, we’ll examine one popular option that might suit a real estate investor who is on a low income or may lack significant savings. We’ll answer the question, “What is a graduated payment mortgage?”, examine how they work, consider the pros and cons, and explain how a graduated payment mortgage differs from other types of mortgage.
What Is a GPM?
A GPM, or a Graduated Payment Mortgage or graduated loan, is a type of mortgage. The payments start at a relatively low rate and increase over time to a higher level. A graduated payment mortgage is an excellent option if you want to purchase an income property while your current income is low to moderate but you expect it to rise significantly over the next five to ten years.
On average, the payments will increase between 7% and 12% every year until a maximum payment amount is reached.
Most GPMs are insured by the FHA (Federal Housing Administration) and come in 15-year and 30-year varieties. You’ll often find them referred to as a Section 245 loan.
A graduated payment mortgage is a self-amortizing loan, which means that the debt will be repaid entirely by the end of the loan period.
GPMs are popular with first-time buyers and people looking for real estate financing.
However, this kind of financing has some drawbacks, so it’s important to do your homework and ensure it’s the right option.
How Does a Graduated Payment Mortgage Work?
With a graduated payment loan, the borrower makes lower monthly minimum payments up front, increasing steadily.
A GPM has a fixed interest rate attached. However, it tends to be much lower to help people with low incomes.
The monthly bill with a GPM starts with smaller payments, but they inevitably grow by around 7% to 12% annually as time passes. This type of loan will have a maximum payment ceiling, and once it’s reached, the maximum payment is made until the mortgage is fully paid.
Criteria You Must Meet
GPMs are most often FHA-insured, which means there are specific criteria all borrowers have to meet. They include:
- A minimum of 3.5% down payment
- Paid FHA mortgage insurance premiums
- Purchasing a single-unit, owner-occupied property
What Is an Owner-Occupied Property?
An owner-occupied property is a piece of real estate in which the person who holds the title also uses the home as their primary residence. It’s a term commonly associated with real estate investors who live in a property but rent out separate spaces to tenants.
Some attractive financing options for owner-occupied properties, such as graduated payment mortgages, are generally reserved for homeowners. At the same time, you can create rental income with the property by renting out spaces you’re not using.
However, there are specific requirements you need to meet to qualify as an owner-occupant. For example, you must move into the property within 60 days of closing. With most lenders, you must also live in the property for at least 12 months to qualify as an owner-occupant.
The Pros and Cons of Owner-Occupied Rentals
The advantages of investing in owner-occupied real estate include:
- You’re close at hand should there be an emergency.
- You can ensure proper care is taken to maintain the property to your standards.
- Certain loans are only available to owner-occupants, and you can often tap into more affordable financing opportunities than if you were an investor or absentee owner. As well as GPM, other financing options include FHA loans, VA loans, or conventional loans.
There are, of course, also some disadvantages, for example:
- You could be living with noisy neighbors or tenants who will do nothing but complain while you’re at home in your unit.
- Finding renters will be much more challenging, as many tenants do not want to live in the same property as their landlord.
- An owner-occupied landlord does not earn passive income. On the contrary, there is a lot of hard work involved, such as managing tenants and maintaining the property.
Available GPM Options
There are five FHA GPM plans available. Three of them allow mortgage payments to increase at 2.5%, 5%, or 7.5% during the first five years of the loan.
The other two plans increase payments at 2-3% annually over 5 or 10 years. At the beginning of the sixth year of a 5-year plan and in the eleventh year of a 10-year plan, the payments level out for the remaining mortgage years.
The Pros and Cons of Graduated Payment Mortgages
As with any financing option, there are pros and cons. Check out the following lists, and they’ll help you decide whether you want to proceed with your graduated payment loan application.
Pros
- Qualifying for a home loan becomes easier.
- You’ll be able to purchase your income property much sooner.
- You’ll get more home for your money.
- In the beginning, lower payments are required.
- Increased flexibility about monthly expenses.
- The mortgage evolves with your income over time.
Cons
- There is an increased risk of financial issues if your income doesn’t grow.
- The overall costs are higher than a conventional mortgage.
- Negative amortization is a possibility that will add to the loan principal.
- To take the best advantage of this type of mortgage, you need to predict your future income accurately.
- Prepayment penalties may be attached.
Graduated Payment Mortgages and Negative Amortization
Negative amortization means the loan balance grows rather than shrinks, and with graduated payment mortgages, this risk exists. Whether it happens depends on the interest rate level, for example, if the interest payment is higher than the initial monthly payment overall.
Imagine you’re getting a $200,000, 30-year GPM, but the fixed interest rate is 5.7%, and monthly payments increase 5% annually for the first five years.
In the first year, the interest payment is higher than the monthly payment, which adds to the loan balance.
By the second year, the monthly payment will increase by 5%. Since the monthly payment is now higher than the interest payment, the balance is now being paid down instead of negatively amortizing.
Negative amortization is a risk for several years at the beginning of the loan term. However, the mortgage will be organized so that the entire balance will still be repaid by the end of the term. Nevertheless, it does mean that the mortgage will ultimately cost more because the loan principal grows at the start of the repayment period.
How Do Graduated Payment Mortgages Differ From Adjustable Rate Mortgages?
On the surface, a graduated payment mortgage and an adjustable-rate mortgage may seem very similar, but they are not the same thing.
With an adjustable-rate mortgage, you can expect the rate to fluctuate periodically to reflect the market interest rate. The rate is adjusted occasionally but not on a fixed schedule. The interest rate can also go down and up because it is based on the going market rate.
On the other hand, with a graduated payment mortgage, the interest rate will only go up.
How Are Graduated Payments Calculated?
Graduated payments are calculated using the mortgage loan amount, the interest rate, the annual graduation rate, and the number of graduations applied. If you want to know in advance, there are online loan calculators you can use.
Mashvisor, for example, has an Investment Property Calculator (also called a rental property calculator). It’s been created specifically for investors and helps you calculate ballpark estimates of your costs.
The Bottom Line
The biggest risk of a GPM is that your income might not rise as quickly as you were hoping. If this happens, you’ll be left with mortgage payments that are getting higher and higher, and there’s no way you can afford them. If you’re considering a GPM, the best thing you can do to minimize this risk is to do the math. If your earnings grow the way you hoped, ensure you’ll still be able to afford the mortgage in future years.
Something else to be aware of is that you’ll pay more interest over the mortgage life. On the other hand, if you choose a mortgage with payments that remain the same over the life of the loan, you’ll pay less in interest.