COFI ARM Loans - Information and Advice

"COFI Loan Pros and Cons - Are COFI ARM Loans Right For You?"

The Pros and Cons of COFI ARMs
In the 1980s, some California savings and loan institutions came up with a new twist on an adjustable-rate mortgage or ARM loan. In this one, the interest rate would float up and down with the average interest rate paid on deposits in their area. That way, the interest rate spread between their mortgage assets and their deposit liabilities would be stable. And that's how COFI ARM Loans were created.

To measure their average deposit rate costs, these California thrifts used the "11th district Cost Of Funds Index," or COFI. The "11th district" refers to the Federal Home Loan Bank System's western region, which consists primarily of California.

What is distinctive about COFI ARM Loans?
When a prospective borrower first hears about a COFI ARM Loan, he or she often will ask, "Is COFI a good index or a bad index for me?"

In fact, over periods of a year or longer, all interest rate indexes tend to move together. There probably is no such thing as a good index or a bad index.

The COFI index tends to move a bit more slowly than other indexes, which is good for you if rates are rising but not good for you if rates are falling.

However, the impact of this sluggishness on the performance of your ARM is much less than the impact of other features of the ARM.

In fact, what is distinctive about COFI ARM Loans is not the index per se, but the creativity that lenders have used in designing COFI ARM products.

Historically, the ARM products tied to indexes of Treasury rates have been relatively standard, while those tied to COFI or LIBOR (another index that I will not get into here) have shown more variety.

What the greater variety means to you as a borrower is that there are more opportunities to get a COFI ARM deal that is particularly good--or particularly bad. You have to scrutinize the characteristics carefully.

COFI Loan characteristics to watch for
If I told you that you could get a COFI ARM for 3.875 percent, in an environment where Treasury ARM start rates are close to 6 percent, you might get pretty excited.

However, what if I told you that this particular COFI ARM Loan has no rate cap, and that it adjusts after just three months?

That means that in three months your rate could be 9 percent or higher, while with a one-year Treasury ARM your rate would still be at 6 percent, most likely with a cap of 8 percent in the second year.

Questions to ask about any ARM product, not just COFI Loans, include:

• What would the interest rate be today if the rate were fully adjusted, based on the current value of the index?

• How long before the interest rate can adjust? By what amount can the rate adjust at that time? At the next adjustment period? Over the life of the loan?

• Is there a prepayment penalty? If so, then at the next downturn in rates when your friends are happily refinancing into fixed rates, you may feel stuck.

• Is there a conversion option? This is the opposite of a prepayment penalty--the loan may be allowed to convert to a fixed rate. However, the conversion feature may not be as valuable as one might think--what if the rate that you convert to is 0.5 point above the market rate for fixed-rate mortgages at the time you convert? How can you be sure that you will have the option to convert to a competitive fixed rate?

• How many points have to be paid up front? With a fixed-rate loan, by paying more points up front you are "buying" a lower interest rate for a long time. For some people, it may make sense to pay as many as 4 or 5 points. However, with an ARM, you may only enjoy the lower rate until the first adjustment period. It rarely is advantageous to pay more than 1.5 points with an ARM.

 
COFI Loans without rate caps
One of the more creative designs of COFI ARM loans uses a payment cap instead of an interest rate cap. This increases the borrower's financial risk.

Suppose that your ARM starts at 5 percent and adjusts after six months, at which time the formula says that the rate should be 7.5 percent. If you had an interest rate cap that said that the rate could not adjust more than 1 percent every six months, then you would have only a 6 percent rate.

With a payment-capped ARM under the same scenario, the good news is that your monthly payment does not change after six months. The bad news is that the interest rate adjusts fully to 7.5 percent. How can this work?

When your interest rate goes up but your payment stays the same, more of your monthly payment goes to interest and less goes to bring down the principal balance of the loan.

In fact, it is very likely that your monthly payment will not even be enough to cover the interest, and the interest shortfall will be added to your outstanding balance.

In other words, the outstanding balance on your loan will increase during the period when the payment cap is binding.

Do many people take COFI ARM Loans?
Over the years, hundreds of thousands of borrowers have taken out mortgages linked to COFI, and most of them are satisfied.

However, because some of the COFI products do not offer rate caps or other key features to protect the borrower, you need to be particularly careful to study the product before you make your choice.

COFI Loans are "caveat emptor" or buyer beware.

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