September 20, 2004, Revised November 21, 2006
"I was told that the only way I could qualify for the loan I wanted was
with a GPM. What is that?"
GPM stands for "graduated payment mortgage", meaning a mortgage on which
the payment starts low and rises over time. Since the initial payment is
used to qualify the borrower, the GPM may allow a borrower to qualify
who would not qualify with a standard fixed-rate mortgage (FRM).
How a GPM Works
For example, the mortgage payment on a $200,000 FRM for 30 years at 6%
is $1199. Stretched over 40 years, the payment would be $1100. But the
initial payment on a 30-year GPM at 6.50%, on which the payment rises by
7.5% a year for 5 years, is only $941. The interest rate on the GPM is
fixed, just as it is on a standard FRM.
The quid pro quo for the low initial payment is a larger payment later
on. The payment on the GPM rises for 5 consecutive years, reaching $1351
in month 61, where it stays for the remainder of the term.
The initial payment on a GPM does not cover the interest. The
difference, termed "negative amortization", is added to the loan
balance. In the example, the loan balance peaks at $202,905 in month 36
before it starts down. Not until month 61 does the balance fall below
$200,000. This rising balance is a feature that lenders don’t like, and
it is why they charge a higher rate for GPMs than for FRMs.
Alternative Types of GPMs
Other GPMs have different rates of payment increase over different
periods. One has a 3% graduation rate over 10 years instead of 7.5% for
5 years. Assuming the same 6.5% rate, the initial payment would be
higher at $1031, rising to $1388 in month 121. Negative amortization,
however, is smaller, peaking at $200,908 in month 24.
GPMs Versus Temporary Buydowns
The GPM is not the only type of mortgage with rising payments. FRMs with
temporary buydowns also carry lower payments in the early years. For
example, the payments in the first two years on an FRM with a 2-1
buydown are calculated at rates that are 2% and 1% lower than the rate
on the FRM. On a 6% 30-year FRM of $200,000, the first year payment
would be $955, rising to $1074 in year 2 and to $1199 in years 3-30. And
the buydown loan amortizes as it would without the buydown – there is no
negative amortization!
For a temporary buydown to work, however, someone must fund the required
buydown account. Withdrawals from this account supplement the payments
made by the borrower in years 1 and 2 so that the lender receives the
same payment ($1199) throughout. The $4436 required for the buydown
account must be provided either by the borrower or the home seller. GPMs
don’t require a buydown account.
GPMs Versus Option ARMs
Rising payments are also available on many types of adjustable rate
mortgages (ARMs), most notably on the flexible payment or option ARM
that I have written about in the past. Under its minimum payment option,
the first-year payment on this ARM is calculated at rates as low as
1.95%. On a $200,000 30-year loan, this amounts to $734, strikingly
lower than the $941 on the 5-year GPM.
Increases in the ARM payment, furthermore, are limited to 7.5% a year
for the first 5 years, just like on the 5-year GPM. In year 5,
therefore, the ARM payment has risen to $980 as compared to $1256 on the
GPM.
In month 61, however, the chickens come home to roost. The GPM payment
rises by 7.5% one more time, to $1351, where it stays. The ARM payment
increase, on the other hand, could be 7.5%, or it could be 75% or even
higher, there is just no way to know. As can be seen from the tables in
Flexible
Payment ARMs, the range of possible outcomes is very high.
The core difference between the GPM and the option ARM is that the
borrower with a GPM knows in advance exactly how and when the payment
will change. The ARM borrower, in contrast, is throwing the dice. A new
eruption of inflation is bound to cause market rates to rise markedly,
which will clobber all ARM borrowers, but especially those who make the
minimum payment on an option ARM.
GPMs carry risk to borrowers, who must be able to meet the scheduled
rise in payments, but the risk is known and at least partly within their
control. The one broad economic event that would hurt them is severe
deflation, which at this juncture is extremely unlikely.