Everything You Need to Know About Growing Equity Mortgages

What Is a Growing Equity Loan?

A growing equity loan, or growing equity mortgage (GEM), is an alternative type of mortgage with a fixed interest rate. The amount paid monthly is increased over time in accordance with an agreed-upon payment schedule. 

This translates to more money applied to the principal of the loan. The borrower shortens the loan’s life and accrues less interest on the loan. These loans also help to increase home equity more quickly than a traditional mortgage. 

The growing equity mortgage is a program that is designed to help homeowners accumulate equity in their homes faster. With this loan program, buyers start out with a regular mortgage payment. After a certain amount of time, the monthly required payment will increase. With a growing equity loan, you will accumulate equity in your home faster than normal. This means the mortgage can be paid off at a much quicker rate. Growing equity mortgages are usually paid off in just 15 years rather than the typical 30.

Details on the Growing Equity Mortgage

The growing equity mortgage is a home loan with a fixed interest rate and monthly payments that increase over time. The increase in payment amount helps pay down the principal on the mortgage. By increasing the monthly payment amount, the home buyer can shorten the period of the mortgage. This means the loan is paid off more quickly than it would be with the normal amortization period. The FHA-insured GEM program is called a 245(a) loan.

Getting a growing equity mortgage is best for homeowners who expect their income to increase throughout the life of the mortgage. With a growing-equity mortgage, the borrower agrees to a fixed-rate mortgage. The monthly payments increase over time according to a set schedule. Although the payments increase over time, the schedule helps the borrower plan for the changes.

The interest rate on the loan does not change, and the borrower will never experience negative amortization. The first payment is a fully amortizing payment. As the payments increase, the additional amount above a fully amortizing payment is applied directly to the remaining mortgage balance. This shortens the life of the mortgage and increases savings on interest.

What a Growing Equity Mortgage Is Not

Growing equity loans are often confused with graduated payment loans, which follow the same structure, with one key difference. Instead of paying more per month and building equity, a graduated payment loan sees the borrower pay less than the required monthly amount, resulting in negative amortization. 

A graduated payment mortgage also has a fixed interest rate and payments that increase at set intervals. However, a graduated payment mortgage has negative amortization. Unlike a growing-equity mortgage, initial payments on a graduated payment mortgage are lower than a fully amortizing payment would be. In fact, they are less than an interest-only payment. This creates negative amortization.

The answer all comes down to the difference between amortization and negative amortization. A graduated payment mortgage has a fixed interest rate and monthly payments that increase. The first round of mortgage payments are set quite low. They are so low that they probably won’t cover the cost of monthly interest that is being accrued. By making the minimum payment due each month, there is no interest savings. Instead, this can dramatically increase the amount of debt on the loan.

How do Payments for a Growing Equity Loan Work?

The payments for growth-equity mortgages typically rise annually. They usually increase up to 5% per year. In addition to paying off the financing early the schedule helps build up equity in the home that the borrower could leverage if needed. 
 
Each growing equity mortgage monthly payments increase by a fixed percentage during each year of the loan. The initial year's payments to principal and interest are based on a 30 year level payment schedule. The amount of the monthly payments for the next 12 months increases each year. 

The increase is usually between 1 and 5 percent depending on the plan selected. The actual term of the mortgage won’t be longer than 22 years. It might be as low as 15 years, depending on the specific growing equity mortgage plan and interest rate selected.

How Does Interest on a Growing Equity Loan Work?

Paying off a mortgage in half the time seems like a good deal, but maybe it's too good to be true. How exactly does a growing equity mortgage work? A GEM has a fixed interest rate. This interest rate is often lower than the current market rate, because payments will increase over time. The increase occurs gradually, either monthly or annually. It's usually based on an index like the U.S. Commerce Department Index. However, it also might be based on a schedule that you and the mortgage company have agreed upon.

Because the payments increase so often, the borrower is paying such high amounts that the interest doesn't increase. No negative amortization is allowed. Negative amortization is when the amount of money owed increases because the monthly payment doesn't cover the interest due. It typically occurs when interest is high and payments are low. 

You may see a similar situation with a credit card with negative amortization. For example, when someone pays only the minimum on a high-interest credit card that carries a large balance. But a growing equity loan doesn’t experience negative amortization. The high monthly payments reduce more of the principal of the loan, and not just the interest. This means a buyer can pay off a 30-year mortgage in 15 to 20 years, and sometimes even less.

Why Get a Growing Equity Loan?

Some homeowners may have significant future earnings potential. A growing equity loan is ideal for these buyers. These loans allow them to aggressively satisfy their repayment obligations.

Many lenders offer growing equity payment schedules as a way of offsetting a lower down payment made by the borrower. Sometimes, it is offered when borrowers do not qualify for a conventional home loan. One example of this is the growing equity loan option offered by the Federal Housing Administration.

Since the growing equity loan initial payment amount is higher than the monthly amount required to pay off the loan over time, the payments ensure that there would never be negative amortization of the loan, which implies making payments of less than what is typically required on a monthly basis in order to pay off the loan principal and interest.

What are the Risks of a Growing Equity Mortgage?

Between the shortened term and the total money saved, it seems like more people should be using a GEM. There is really only one drawback to a GEM, but it's a big one. With any mortgage, there is always the possibility that the borrower won't be able to make the payments. Maybe the borrower loses a job or changes careers, and can no longer afford to pay the mortgage. With a GEM, this threat is compounded. Not only does the borrower have to keep making payments, but the payments keep getting larger. Being unable to keep up could cause a borrower to end up in foreclosure.

Not only does someone have to continue making money, but they need to continue making more money. A GEM borrower's earnings must outpace the cost of living. His or her job needs to continue paying more through raises and promotions. Even if the borrower's salary increases, it may not be enough to keep up with the payments. And if the borrower can't keep up with those payments, he or she could lose the house. GEMs can be beneficial, but borrowers should consider the risks.

Why are Growing-Equity Mortgages Offered?

Lenders offering growing equity loans help low and moderate-income families purchase homes by keeping the initial costs down. Growing equity mortgages also protect lenders against loan default on mortgages for properties. 

Applying for a growing-equity mortgage can be the same as applying for other types of mortgages, with comparable credit requirements. Buyers may find options for lower down payments associated with this type of mortgage, helping those who would otherwise not likely be able to afford the upfront costs of purchasing a home. Additionally, a growing equity loan can be offered to those who might not qualify for conventional mortgages. The FHA offers a growing-equity mortgage program specifically for this purpose.

FHA guidelines allow those with limited income to apply for growing equity mortgages. But these buyers must also have a reasonable expectation of increases to their earnings. When a growing equity mortgage is insured through FHA, the lenders are given protection in case of default by the borrower. FHA insurance for growing-equity mortgages can cover new purchases, refinancing, and rehabilitation of properties. The financing can also be for units in condominiums or shares in cooperative housing.

Who Applies for Growing Equity Loans?

Growing equity mortgages are ideal for those who anticipate their salary and other annual earnings to increase over time. These mortgages are intended for those who expect their incomes to grow appreciably. The borrower must also use the property as their primary residence.

A growing equity mortgage can help first-time home buyers and others with limited incomes. They out with a low monthly mortgage payment that will increase gradually over time. Therefore, these buyers can purchase a home sooner than they would be able to through conventional financing programs.

Who Benefits Most from a Growing Equity Loan?

FHA’s Section 245(a) enables growing equity mortgages: home loans tailored for first time home buyers or young families. These homebuyers may be unable to meet the many upfront and monthly costs that are involved in a traditional mortgage.

They are able to do so with the help of a growing equity mortgage. With a growing equity mortgage, payments start small and increase gradually over time. As the mortgage payments grow the additional payment is applied toward the principal on the loan. This reduces the mortgage term.

But just being a first-time homebuyer doesn't automatically make someone a good candidate for a growing equity loan. What if that first-timer is already settled into a career with few promotions down the line? That borrower probably won't be able to make the increased payments because his income will stay about the same.

Meanwhile, someone who has just graduated and begun a new career is probably not making a lot of money yet. But he or she may be working for a company with a lot of growth potential. Maybe they are on a career track leading to a much higher-paying job than the one they have today. With the anticipated increased salary, this prospective home buyer is an ideal candidate for a growing equity loan. Someone considering a GEM should be sure that he or she will earn more money before the mortgage payments increase.

What are the Pros of a Growing Equity Loan?

One of the major advantages is that you are going to save quite a bit of money on interest. With this program, your mortgage payments will increase periodically. This means that you will apply more of your payment to the principal. When you pay down the principal quicker, you will have less interest accumulate on your loan. Because of this, you can save a substantial amount of money over the course of your loan. 

Another advantage is that you are going to be able to pay it off faster than normal. Imagine what it would be like to completely pay off your mortgage. You wouldn’t need to worry about your biggest bill every month anymore. You can do exactly that with a growing equity mortgage.

Another advantage of this loan is that you are going to be able to accumulate equity in your home faster. Having equity in your home can be very beneficial in case you need to borrow against it in the future. By utilizing a home equity loan or refinancing, you could tap into your equity for a number of different uses. Borrowing against your equity can make a lot of sense. Doing so allows you to deduct the interest from your loan from your taxes.

What are the Cons of a Growing Equity Loan?

The biggest disadvantage of this program is, of course, that your mortgage payments will go up over the years. You’re already starting out with a full mortgage payment from the beginning. This is not like a graduated payment mortgage. With those, you actually start out with a low monthly payment and work your way up. Instead, you’re starting with a full payment and adding to that amount. In other words, you can find yourself with a substantial mortgage payment by the end of the loan.

Because of these increasing mortgage payments, you’ll need to increase your income at the same rate—or even faster. You’ll need to get raises at your current job or find better paying jobs as your career progresses. Many people have trouble with this scenario because they are unable to increase their salary to keep up with the mortgage.

What Type of Assistance is Available with a Growing Equity Loan?

The Department of Housing and Urban Development offers FHA mortgage insurance to help promising first time home buyers. Since many are young families, many of these buyers aren’t able to afford large upfront costs and down payment requirements.

Each FHA section has different requirements to satisfy in order to be approved for the loan. These depend on the type of property. There are five different plans and sections:

• Section 203(b): FHA mortgage insurance for single to four-family homes

• Section 203(k): This program qualifies buyers looking to refinance, rehabilitate, or purchase a home

• Section 203(n): For home buyers in need of cooperative housing, this FHA section is appropriate

• Section 234(c): Growing Equity Mortgages for condominiums

The first round of annual payments for a growing equity loan goes to the loan principal. Interest is be set according to a 30 year pay schedule. Increases can add an additional 1% to 5% each year. However, this may vary depending on the final mortgage requirements. In spite of the 30-year pay schedule, a growing equity mortgage should not be longer than 22 years.

Growing Equity Loans: In Review