What Is a Graduated Payment Mortgage (GPM)?

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).

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.

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.

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.

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.

"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.

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