What is a Graduation Rate
The graduation rate is the percentage that monthly payments increase for payment on a graduated payment mortgage (GPM). This rate is determined at the beginning of the loan, and the monthly payments increase by that rate each year, for five or ten years. After the scheduled rise in the payment rate each year, the mortgage payment then remains fixed at the new, higher rate for the duration of the loan.
With a graduated payment mortgage, the initial monthly payments are below those of a fully amortizing payment. This allows the loans to be accessible to borrowers who currently have a lower income, but expect their income to increase in the next several years, allowing them to make higher payments later. By increasing the payment throughout the graduation period, the borrower’s monthly payment eventually becomes large enough to amortize the mortgage over its remaining term.
BREAKING DOWN Graduation Rate
The graduation rate for a GPM varies, depending on the borrower’s payment plan. The FHA offers five different plans for GPMs. For three of these plans, graduation rates may be 2.5 percent, 5 percent or 7.5 percent. This percentage is the amount that the payments increase each year for the first five years of payments. The other two plans the FHA offers increase at a rate of between 2 and 3 percent a year, respectively, for 10 years.
Graduated payment mortgages appeal to borrowers who don't otherwise qualify for a mortgage based on their income. This is because for the first five to ten years of the loan, their payments are so small as to create negative amortization. Negative amortization means that the payments do not actually cover the interest on the loan. Thus, the balance due on the loan actually goes up for those few years, even though the borrower makes regular payments. One drawback to GPMs is that though the payments are small at first, ultimately, the borrower ends up paying a larger amount for their home, due to the negative amortization.
Qualifying for a Graduated Payment Mortgage
Graduated Payment Mortgages are a type of loan offered by the Federal Housing Administration to help make buying a home accessible to people with lower incomes. These types of loans are also called Section 245 loans. These loans only apply to individuals purchasing a single-unit dwelling for their primary residence.
Eligibility depends on a buyer's credit history, income, and perceived ability to repay the loan. Because the payments for the first several years are lower than for a traditional loan, some qualify only for a graduated payment mortgage, but not a traditional mortgage. One example is a person currently in law school. Law students make very little or no money, and typically have substantial debt. However, when they finish their degrees, they typically earn a higher income, which allows them to keep up with the higher monthly payments of a GPM.