Which ARM is the Best Alternative?

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%? You can have all that with the 11th  District Cost of Funds (COFI) Adjustable Rate Mortgage.

 

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  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  adjustment period is simply 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 you wanted 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 you 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 very rare 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), which is 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 also begins to rise.

 

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 just 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 1980’s when interest rates were pushed up artificially to combat the inflation of the 1970’s.

 

Make Only Part of Your Payment?

 

This is the really interesting feature of the loan. You do not have  to make the whole 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 that  is due on the loan that particular month, but does not pay anything  towards the principal. Finally, the third option gives you the choice to pay even less than that and is called the “minimum payment.”

 

The minimum payment when you start your loan can be calculated as low as 1.95%. Keep in mind that this is not the note rate on your loan, but just a way to calculate your minimum payment.

 

Deferred Interest and Amortization

 

Of course, if you only make the minimum payment each month, you are  not paying all of the interest that is currently due that month. You are deferring some of the interest that is currently due on the loan so you will have to pay it 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 payment is $1000 this year, next year the most  it could be is $1075. This continues each year until your payment is  approximately equal to the payment at the full note rate.

 

Just in case, there are fail-safes built into the loan. If you  continue making only the minimum payment and your current balance ever  reaches 110% of the beginning balance, the loan is re-amortized to make  sure you pay it off in thirty years (or forty years, whichever option  you chose). Every five years the loan is re-amortized to make sure it  pays off within the term of the loan.

 

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 is difficult 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 a quick and easy loan approval.

 

Sub-Prime COFI ARMs

 

Some people have less than perfect credit and they 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 end result is that your interest rate would be about one  percent higher.

 

Who Should Get This Loan?

 

Most people who get the COFI ARM are purchasing a home between  $300,000 and $650,000, but it is not limited to that. It is a real  favorite of those working in the financial industry and those with  higher incomes. One reason these groups like this particular loan is  because they consider any deferred interest to be an extended loan at a  very attractive 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 if they choose.

 

Another reason borrowers like the loan is because it allows for tax  planning. The borrower can defer interest payments and at the end of the year, analyze their tax situation. 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 with the intention of living in it for only a few years before you move up to a bigger home, the COFI ARM makes  sense, too. With this loan and its low start payment you can often  qualify for a larger home than you can when applying for a fixed rate  loan. This allows you to skip the intermediate purchase and move up  immediately to the home you really want, which makes more sense and  saves you money.

 

If you buy a home then sell it to move up to a bigger home, you are  going to have to pay a 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 really 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. If you  buy your ideal home now, you save five years of mortgage payments.  Depending on your loan amount, that can be a lot of cash.

 

Conclusion

 

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. 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.