COFI (pronounced coffee) stands for Cost of Funds Index. Such an index is used with certain types of adjustable-rate mortgages (ARMs) to provide a basis for how the interest rate on those loans is periodically changed to reflect current market conditions.

A COFI represents an average of the interest rates paid or charged on certain financial products or services offered by institutions included in the COFI. One of the most commonly used has been the 11th District Cost of Funds Index, which is made up of a weighted average of interest rates paid on savings and checking accounts offered by banks in the states of Arizona, California and Nevada.

Another is the Federal Cost of Funds Index, which is based on an average of interest rates paid on marketable Treasury bills and notes. Both the 11 th District and Federal COFIs are calculated monthly.

COFI interest rates tend to fluctuate more slowly than other types of indexes used as ARM benchmarks. This makes them particularly appropriate to use with ARMs whose rates reset frequently, such as once a month (other ARMs may keep the same interest rates for years).

Rarely available today

COFI mortgages used to be fairly common, but they've largely disappeared since the collapse of the housing bubble. Prior to that, they were primarily used as a rate benchmark for option ARMs, a type of loan that offered flexible monthly payments, allowing borrowers to choose and switch among various payment levels. Some of these options included interest-only payments and even negative amortization (in which the payments didn't even cover the full monthly interest charges), so borrowers would make no progress on paying down the loan or even see their loan balance grow.

Option ARMs can be a useful product for borrowers who wish to minimize their mortgage payments for a period of time and have the financial means to handle a sharp rise in payments once the loan reaches the amortization phase, when payments against the loan principal become due. They've often been used by the self-employed or others with unpredictable incomes who wish to avoid being committed to a large monthly mortgage payment, and by wealthy borrowers who wish to direct their cash flow elsewhere.

COFIs and the housing bubble

Unfortunately, in the early 2000s these loans began to be widely sold to borrowers of limited means with an emphasis only on the low monthly payments initially available, with little attention given to the higher payments these loans would eventually require. Not surprisingly, many of these borrowers were unable to afford the new, higher payments and option ARMs were widely blamed as one of the "exotic" loan types responsible for the housing bubble and crash.

These days, COFI mortgages and option ARMs are hard to find. Lenders who do offer them are likely to be those dealing in specialty niches for well-qualified clients. If you read the financial press, you'll still see regular reports on the latest rates for the 11th District COFI, which continues to serve as a benchmark for many existing loan that are still out there, even though few new COFI mortgages are currently being originated.

The mortgage market does move in cycles and it is likely the COFI loans and option ARMs will eventually make a comeback of sorts, though they will likely be limited to well-qualified buyers who understand and are prepared to handle the risks inherent in such loans.

Published on September 24, 2010