Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Cost of funds index questions

Dr. Don,
Is a COFI loan misunderstood? What are the good things about a COFI loan? What are the bad things?
Thanks,
Linda Latte

Dear Linda,
COFI stands for cost of funds index. COFI is one of the indexes used in pricing adjustable-rate mortgages (ARMs). Most adjustable-rate mortgages that are priced based on a COFI use the cost of funds for the 11th district of the Federal Home Loan Banks in San Francisco, but there are 12 districts in the Federal Home Loan Bank System. The 11th district describes the COFI in its FAQ page as:

The cost of funds index (COFI) is not an interest rate. It reflects the average interest paid by savings institutions for their various sources of funds over a specified period of time. Deposits in checking and savings accounts -- including certificates of deposit, money market deposit accounts, transaction accounts, and passbook accounts -- are the primary source of funds for most savings institutions. Other sources of funds include loans obtained through the credit programs of the Federal Home Loan Bank of San Francisco (known as "advances") and money borrowed from other financial institutions.

The index tends to follow or lag changes in interest rates in the financial marketplace. That characteristic makes them less popular when interest rates are heading lower and more popular as interest rates head higher. The index also tends to be less volatile than LIBOR or Treasury bills, making the mortgage rate less volatile.

There is a monthly COFI index that is released on the last business day of the month following the index month. That means that the index for April is released on the last business day of May. There's also a semiannual COFI index that is released approximately six weeks after the end of the six-month period.

Negative amortization on an adjustable-rate loan means that any interest expense not covered by the mortgage payment is added to the loan balance. This typically happens when the mortgage payment is capped over a period but the interest rate is not. COFI-based ARMs often have a payment cap but not a periodic rate cap.

Along those lines, borrowers can choose between making a fully indexed payment or a minimum payment. Any resulting negative amortization is deferred interest. The deferred interest option can help when it comes to budgeting or tax planning by shifting expenses into another tax year. Consult your tax adviser to confirm the tax deductibility of the mortgage interest expense.

As they would with any adjustable-rate mortgage, the borrower needs to understand how the interest rate adjusts, how that adjustment affects the payment and, in the case of negative amortization, the loan balance. Interest rate movements can be limited by periodic or lifetime caps and floors. When you borrow using an adjustable-rate mortgage, you're taking on interest rate risk. You need to understand the risks you face before committing to the loan.

You can follow changes in COFI and other interest rates using Bankrate's Track Rates feature. Bankrate's Mortgage Decision Tools can also help you decide if an adjustable-rate mortgage is right for you.