Graduated payment mortgage

Key Takeaways

• A graduated payment mortgage carries one fixed interest rate, but the payment amount rises on a schedule set at closing until it reaches its final level.
• Early payments can be smaller than the interest accruing that month, so the loan balance grows for a time before it starts to fall. That is negative amortization.
• The design targets a buyer who expects income to rise and wants to qualify at a lower starting payment, and the trade-off is slower equity growth.
• Washington requires a plain-language disclosure summary of all material loan terms within three business days after the lender receives the application (RCW 19.144.020).

What It Means

A graduated payment mortgage is a fixed-rate loan whose payments start low and step up on a set schedule to a higher final level. The rate never moves. What moves is the payment, and it moves on dates written into the note before the borrower ever signs. A typical structure raises the payment by a fixed percentage each year for the first five to ten years, then holds it flat for the rest of the term.

The early payments can be so small that they do not cover the interest the loan is accruing. When that happens, the shortfall is added to the principal and the balance rises, which is Negative Amortization. The balance only starts falling once the stepped-up payment overtakes the interest. That is the whole bargain: a buyer who expects rising income can qualify today at a payment a straight Fixed Rate Mortgage would not allow, and pays for it with slower Amortization and more interest across the life of the loan. It is one of a dozen structures worth knowing, and our roundup of loan types every broker should know puts it next to the rest.

How It Works in Washington

Washington does not have a statute that creates or forbids graduated payment mortgages. What it has is a disclosure rule. RCW 19.144.020 says a residential mortgage loan may not be made unless a disclosure summary of all material terms is placed on a separate sheet of paper and given to the borrower within three business days after the lender receives the application, and a new summary must follow within three days if a material term changes. The summary has to state, among other items, whether the loan carries a prepayment penalty, whether it contains a Balloon Payment, and whether the payments will adjust. A rising payment schedule is exactly the kind of material term that belongs there.

The broker's own duty runs on a separate track. RCW 18.86.030 requires a broker to disclose all existing material facts known by the broker and not apparent or readily ascertainable to a party, while the same section says the broker has no duty to independently verify the accuracy of statements made by others. In practice that means a broker who knows the buyer's payment jumps in year two says so, and sends the buyer to the lender for the numbers. The Washington Department of Licensing administers those license law duties.

Example

Priya Raman buys a townhouse in Kent for $525,000 with $105,000 down and a $420,000 graduated payment mortgage at a fixed 6.5 percent. The note sets the first-year payment at $2,180 of principal and interest and steps it up 7.5 percent every year for five years, reaching about $3,130 in year six, where it stays for the rest of the term.

Two numbers tell the story. A straight 30-year amortizing payment on $420,000 at 6.5 percent would be about $2,655, so Priya qualifies at roughly $475 a month less than she otherwise would. But the loan accrues about $2,275 in interest in month one, and she is only paying $2,180, so about $95 gets added to the balance. Priya owes slightly more after her first payment than she did at closing, and that continues until the stepped-up payment passes the interest. Her mortgage broker's disclosure summary under RCW 19.144.020 has to tell her the payments adjust before she gets that far. Rate movement changes this math, as our piece on interest rates and Washington home sales lays out.

Common Mistakes and Exam Traps

• A graduated payment mortgage has a fixed interest rate. The payment changes on a schedule set at closing, not because an index moved, and that is what separates it from an adjustable rate mortgage.
• Negative amortization is possible with this loan, not guaranteed. It happens only while the scheduled payment is smaller than the interest accruing that month.
• Do not confuse it with a balloon loan. A graduated payment mortgage steps up to a level payment that retires the debt over the term, while a balloon leaves a large lump sum due at the end.