There are several options when it comes to financing your first investment property. When it comes to real estate financing, mortgages are prevalent, plus there are many types to choose from, depending on your needs and current situation.
In this post, we’re going to look at 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?”, look at how they work, check out the pros and cons, and how a graduated payment mortgage differs from other types of mortgage.
What is a GPM?
A GPM, otherwise known as 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, your current income is low to moderate, but you expect it to rise significantly over the next five to ten years.
On average, you can expect the payments to increase at a rate of 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 you can expect the debt to be completely repaid by the end of the loan period.
GPMs are a popular choice with first-time buyers, depending on their circumstances, and people looking for real estate financing.
There are, however, some drawbacks attached to this kind of financing, so it’s important that you do your homework and make sure it’s the right option for you.
How Does a Graduated Payment Mortgage Work?
With a graduated payment loan, the borrower starts out making lower monthly minimum payments up-front. The payments then increase steadily.
A GPM has a fixed interest rate attached. However, it tends to be a much lower interest rate to help people with low incomes.
The monthly bill with a GPM starts out with smaller payments, but they inevitably grow as time passes, by around 7% to 12% annually. 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 3.5% down payment minimum is a requirement.
- FHA mortgage insurance premiums have to be paid.
- You’re only eligible for a GPM if you purchase 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 that’s commonly associated with real estate investors who live in a property but, at the same time, rent out separate spaces to tenants.
There are some attractive financing options for owner-occupied properties that are generally reserved for homeowners, such as graduated payment mortgages. At the same time, you’ve got the chance to create rental income with the property by renting out spaces you’re not using.
However, there are specific requirements you’d need to meet to qualify as an owner occupant. For example, you’d have to move into the property within 60 days of closing. You’ll also need to live in the property for a minimum of 12 months to qualify as an owner occupant with most lenders.
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 being 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 that will think nothing of complaining while you’re at home in your unit.
- You’ll find it much harder to find renters as many tenants are not happy living in the same property as their landlord.
- An owner-occupied landlord is not passive income. On the contrary, there’s 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 a rate of either 2.5%, 5%, or 7.5% during the first five years of the loan.
The other two plans increase payments at a rate of 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 kind of 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 is 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 with regard to monthly expenses.
- The mortgage evolves with your income over time.
Cons
- There is an increased risk of financial issues if your income doesn’t go up.
- The overall costs are higher.
- 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.
- The total cost of a GMP often exceeds a conventional mortgage.
- Prepayment penalties may be attached.
Graduated Payment Mortgages and Negative Amortization
Negative amortization is a term that means the loan balance grows rather than shrinks, and with graduated payment mortgages, there’s a risk of this happening. 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 interest rate is 5.7% fixed with monthly payments increasing 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%. The monthly payment is now higher than the interest payment, so 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 terms. 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 from time to time 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 do grow the way you were hoping, make sure 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 life of the mortgage. 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.