Which ARM is the Best Alternative?

 

The 11th District COFI ARM: Flexibility and Risk ExplainedHow 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%? You can have all that with the 11th District Cost of Funds (COFI) Adjustable Rate Mortgage.

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. However, once you become aware of all the details of the loan, 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 margin is the difference between your interest rate and the index, and it does not change during the term of the loan.

Indexes and the 11th District

It is common to find adjustable rate mortgages tied to indexes like treasury bills, LIBOR, or the 11th District Cost of Funds (COFI). The COFI is the weighted average of interest rates paid out on savings deposits by banking institutions in the 11th district of the FHLB. The COFI index moves slower and lags behind actual changes in the interest rate market, making it more stable.

The Margin and Monthly Adjustments

The margin on the COFI ARM typically ranges between 2.25-3%. Although monthly adjustments sound scary, this is a slow-moving index. The most it has moved in any calendar year since 1981 is 1.6%. The “life-of-loan” cap for the COFI ARM is usually 11.95%.

Make Only Part of Your Payment?

This is the really interesting feature. Each month you get a bill that has at least three payment options:

 

• The full payment at the current interest rate.
• An interest-only payment (pays no principal).
• The “minimum payment,” which can be calculated as low as 1.95%.

Deferred Interest and Amortization

If you make only the minimum payment, you are deferring some of the interest, which is added to the loan and the loan balance gets larger (negative amortization). The payment cap on the loan is 7.5%, meaning the most your minimum payment can increase from one year to the next is seven and a half percent. Just in case, there are fail-safes: if the current balance ever reaches 110% of the beginning balance, the loan is re-amortized.

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 (Stated Income). This is helpful for self-employed borrowers or those who have jobs where it is difficult to document their income. Sub-Prime COFI ARMs are also available for those with less than perfect credit, typically with a higher margin.

Who Should Get This Loan?

It is a favorite of those working in the financial industry and those with higher incomes, as they consider any deferred interest to be an extended loan at a very attractive rate. Homebuyers whose income has peaks and valleys (self-employed or commissioned salespeople) also like the loan for its flexibility. Another reason is tax planning, as deferred interest can be paid off in a lump sum at year-end for tax deduction purposes.

Skipping the Starter Home or Move-Up Home

With this loan and its low start payment, you can often qualify for a larger home than with a fixed rate loan. This allows you to skip the intermediate purchase and move up immediately to the home you really want, saving significant money on commissions and closing costs from a second sale.

Conclusion

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. Something we also did not mention is that most COFI lenders also give you a fourth option on your monthly mortgage statement, which allows you to pay it off quicker.