Graduation Period

A graduation period is the period of time during repayment of a graduated-payment mortgage during which the monthly payment rises by a certain percentage at set intervals, usually annually. The interest rate at which monthly payments are set to increase by is fixed over the entire graduation period. If the actual payment is less than what an interest-only payment would be, negative amortization is created.

Graduation periods are essential features of a graduated-payment mortgage. Graduated-payment mortgages are similar to payment option adjustable-rate mortgages (ARMs); however, payments on graduated-payment mortgages rise at a predetermined rate, whereas adjustable-rate mortgage payments fluctuate based on market forces. The benefit of a graduated-payment mortgage over a payment option ARM is that the borrower knows in advance, and for certain, what the payments and remaining principal balance of the mortgage will be over the entire life of the mortgage.

A graduated-payment mortgage would make sense for homeowners who are certain that their incomes will rise significantly in the future. For instance, doctor who is completing their residency might be a good candidate for such a loan. The average salary for a resident in 2017 was $57,200, compared to an average salary of  $247,319 for licensed medical doctors, while residents must put in three to seven years before they can get their medical licenses. A resident doctor would not be able to afford large mortgage payments until they become licensed, so they may opt for a graduated-payment mortgage that is cheap in the early years, but becomes more expensive during the graduation period.

Let’s assume two resident doctors are married, and they make a combined income of $100,000. In four years, they are almost certain their combined pay will rise to half a million dollars per year. They take out an $800,000 mortgage for a home than costs $1,000,000, but can only afford a  $2,500 monthly payment, which would represent just a 1% interest payment, well below what the market would typically bear. Therefore, the couple might opt for a graduated-payment mortgage, where the interest paid on the loan rises by 1% each year, starting in the fifth year, and leveling out at the above-market rate of 8%, when the couple will make $5,870 payments each month. These higher payments compensate the lender for interest foregone in the early years of the loan. The period in which the interest rate is climbing is called the graduation period.