This page is part of the Homebuyer's Fair
The Pros and Cons of COFI ARMs
by Arnold Kling
November 8, 1994
In the 1980's, some California savings and loan institutions came up with
the idea of an adjustable-rate mortgage whose 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.
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 ARMs?
When a prospective borrower first hears about a COFI ARM, 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 indices 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
indices, which is good for you if rates are rising but not good for you
if rates are falling. (You can see this behavior in the data table we set up to compare COFI with the 1-year
and 3-year Treasury indexes.)
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 ARMs 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.
The characteristics to watch for
If I told you that you could get a COFI ARM for 3-7/8 percent, in today's
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 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, 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 1/2 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 1-1/2 points with an ARM.
Loans without rate caps
One of the more creative designs of COFI ARMs 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 which 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 6 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 ARMs?
Over the years, hundreds of thousands of borrowers have taken out
mortgages linked to COFI, and
most of them are satisfied. Some of the best deals in the market today
are for COFI ARMs, because many lenders believe that an index
that moves with their cost of funds reduces their risk, . 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.
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