How would you like a mortgage loan where you did not have to make the whole payment if you did not want to? Or would you like a loan with an interest rate about 1% below a thirty-year fixed rate mortgage and pay zero points? Or a loan where you did not have to document your income, savings history, or source of down payment? How would you like a mortgage payment of only 1.95%? With the 11th District Cost of Funds (COFI) Adjustable Rate Mortgage, you can have all that.
Sound too good to be true? Sound like a bunch of hype?
Each statement above is true. However, it is also only part of the story, and loan officers do not always tell you the whole story when promoting this loan. Other loan officers may try to scare you away from adjustable rate mortgages. However, once you become aware of all the loan details, it is an excellent way to buy the house of your dreams, especially when fixed rates begin to go up.
ARMs in General
Adjustable-rate mortgages all have certain similar features. They have an adjustment period, an index, a margin, and a rate cap. The adjustment period is how often the rate changes. Some change monthly, some change every six months, and some only adjust once a year. Indexes are simply an easily monitored interest rate that moves up and down over time. Adjustable-rate mortgages have different indexes. The margin is the difference between your interest rate and the index. The margin does not change during the term of the loan.
So if you have an adjustable-rate mortgage and want to calculate your interest rate on your own, all you have to do is look up the index in the paper or on the internet, add the margin, and have your rate.
Indexes and the 11th District
The “Prime Rate” you hear about in the news is one interest rate index, although it is scarce that mortgages are tied to this index. It is more common to find adjustable rate mortgages tied to different treasury bill indexes, the average interest rate paid on certificates of deposit, the London Inter-Bank Offered Rate (LIBOR), or the 11th District Cost of Funds.
COFI ARM Index
The 11th District Cost of Funds (COFI) is the weighted average of interest rates paid out on savings deposits by banking institutions in the 11th district of the Federal Home Loan Bank (FHLB), located in San Francisco. The 11th District includes the states of California, Nevada, and Arizona.
The COFI index moves slower than the other indexes, making it more stable. It also lags behind actual changes in the interest rate market. For example, when rates begin to go up, the COFI index may continue to decline for a couple of months before it rises.
The Margin and Interest Rates
The margin on the COFI ARM typically ranges between 2.25-3%.
Monthly Adjustments Sound Scary, but...
Although you can get a COFI ARM with an adjustable period of six months, you can get a lower margin if you go for the monthly adjustment period. Since the margin plus the index equals your interest rate, the lower margin is an advantage, and most people choose the monthly adjustment.
Monthly adjustments sound scary to the uninitiated, but keep in mind that this is a slow-moving index. Most other ARMS have an annual cap of 2% a year. Since 1981, when the FHLB began tracking the index, the most it has moved during any calendar year is 1.6%. So why get a higher margin to get a rate cap that you probably will not use anyway?
The“life-of-loan” cap for the COFI ARM is usually 11.95%. The most recent year that this cap could have been reached was 1985. Plus, most experts do not expect a return to the interest rates of the early 1980s when interest rates were pushed up artificially to combat the inflation of the 1970s.
Make Only Part of Your Payment?
This is the exciting feature of the loan. You do not have to make the full payment. Each month you get a bill that has at least three payment options. One choice is the full payment at the current interest rate. A second choice allows you to pay only the interest due on the loan that particular month but does not pay anything towards the principal. Finally, the third option gives you a choice to pay even less and is called the “minimum payment.”
When you start your loan, the minimum payment can be calculated as low as 1.95%. Remember that this is not the note rate on your loan but just a way to calculate your minimum amount.
Deferred Interest and Amortization
Of course, if you only make the minimum payment each month, you are not paying all of the interest currently due that month. You are deferring some of the claims currently due on loan, so you will have to pay them later. The lender keeps track of this deferred interest by adding it to the loan, and the loan balance gets larger. Neither you nor the lender wants this to continue forever, so your minimum payment increases a bit each year.
The payment cap on the loan is 7.5%, which also has nothing to do with the interest rate. All it means is the most your minimum payment can increase from one year to the next is seven and a half percent. For example, if your minimum price is $1000 this year, next year, the most it could be is $1075. This continues each year until your amount is approximately equal to the price at the total note rate.
Just in case, there are fail-safes built into the loan. Suppose you continue making only the minimum payment and your current balance ever reaches 110% of the beginning balance. In that case, the loan is re-amortized to make sure you pay it off in thirty years (or forty years, whichever option you choose). Every five years, the loan is re-amortized to make sure it pays off within the loan term.
Stated Income and Other Features
Many COFI lenders allow Homebuyers with good credit to apply without documenting their income, assets, or source of down payment. Of course, you have to make a twenty or twenty-five percent down payment on your home purchase. This is helpful for self-employed borrowers or those who have jobs where it isn't easy to document their income. Plus, some people just do not like the bother of supplying W2 forms, tax returns, and pay stubs. Anyway, it makes for quick and easy loan approval.
Sub-Prime COFI ARMs
Some people have less than perfect credit and are used to being charged outrageous rates for past problems. Some COFI lenders offer this same loan but have a slightly higher starting payment and a higher margin. The result is that your interest rate would be about one percent higher.
Who Should Get This Loan?
Most people who get the COFI ARM purchase a home between $300,000 and $650,000, but it is not limited to that. It is an absolute favorite of those working in the financial industry and those with higher incomes. These groups like this particular loan because they consider any deferred interest to be an extended loan at a desirable rate. By making the minimum payment, they can do other things with the money.
Homebuyers whose income has peaks and valleys, such as self-employed or commissioned salespeople, also like the loan because it provides flexibility in the monthly payment. During a slow month, they can make the minimum payment.
Another reason borrowers like the loan are because it allows for tax planning. The borrower can defer interest payments and analyze their tax situation at the end of the year. If it serves their tax interests, they can make a lump sum payment toward any interest that has been deferred and deduct it for tax purposes.
Skipping the Starter Home or Move-Up Home
If you’re buying a home to live in for only a few years before you move up to a bigger house, the COFI ARM makes sense. With this loan and its low start payment, you can often qualify for a larger home than when applying for a fixed-rate loan. This allows you to skip the intermediate purchase and move up immediately to the home you want, making more sense and saving you money.
If you buy a home and then sell it to move up to a bigger home, you will have to pay REALTOR’S® commissions and closing costs. On a $300,000 house, this would be around $25,000. If you skip buying that home and buy the home you want, you save that money. Plus, you save money in another way. Say you live in your intermediate purchase for five years, then move up and buy another home with another thirty-year mortgage. That is thirty-five years of home loans. You save five years of mortgage payments if you buy your ideal home. Depending on your loan amount, that can be a lot of cash.
So, when rates start going up, this is an attractive alternative to a fixed-rate mortgage. It even makes sense for some borrowers when rates are low. We also did not mention that most COFI lenders also give you a fourth option on your monthly mortgage statement, which allows you to pay it off quicker.