Cost of Funds Index (COFI): Basis for Adjustable-Rate Mortgages

The Cost of Funds Index (COFI) is an index used to calculate the interest rates for adjustable-rate mortgages (ARMs). This index reflects the weighted average cost of savings, borrowings, and advances of a particular financial institution or group of institutions.

The Cost of Funds Index (COFI) is an integral index in the financial and real estate sectors, especially as it relates to adjustable-rate mortgages (ARMs). This index measures the average interest expenses incurred by financial institutions on deposits and other borrowings, serving as a benchmark in setting interest rates for various financial products.

Calculation of COFI

The COFI is typically derived from the weighted average cost of deposits, advances, and other financial liabilities held by thrift institutions, commercial banks, and credit unions in specific regions or markets.

Example Calculation

For instance, if a financial institution has the following financial liabilities:

• Deposits: $1,000,000 at 1% interest.
• Advances: $500,000 at 1.5% interest.
• Borrowings: $400,000 at 2% interest.

The weighted average cost calculation would be:

$$ \text{COFI} = \frac{(1,000,000 \times 0.01) + (500,000 \times 0.015) + (400,000 \times 0.02)}{1,000,000 + 500,000 + 400,000} = \frac{10,000 + 7,500 + 8,000}{1,900,000} = \frac{25,500}{1,900,000} = 1.34\% $$

Special Considerations

COFI is highly sensitive to interest rate changes and economic conditions. It tends to lag behind market rates due to the averaging process and the inclusion of longer-term liabilities.

Applications of COFI

COFI is frequently used in:

• Adjustable-Rate Mortgages (ARMs): Mortgage rates that change periodically are often tied to COFI, giving lenders a stable benchmark reflective of their cost structures.
• Loan Products: Financial products linked to COFI adjust interest rates based on the index, impacting borrowing costs.

Impacts on Borrowers

• Advantages: When market rates are low, borrowers with COFI-tied ARMs may benefit from lower monthly payments.
• Disadvantages: A delay in rate decreases when market rates fall rapidly, possibly leading to higher costs compared to other indices.

Historical Context

The use of COFI gained widespread popularity in the late 20th century, as financial institutions sought more reflective and responsive benchmarks for their cost-based interest rate products. This change allowed for more accurate pricing in line with the institutions’ true financing costs.

Related Terms

• Adjustable-Rate Mortgage (ARM): A type of mortgage with interest rates that periodically adjust based on an index like COFI.
• Prime Rate: The interest rate that commercial banks charge their most creditworthy customers, often used as a benchmark for loans and mortgages.
• LIBOR (London Interbank Offered Rate): A global benchmark for short-term interest rates, widely replaced by other indices after various scandals and regulatory issues.

FAQs

What does COFI stand for?

COFI stands for “Cost of Funds Index.”

How often does COFI change?

COFI is typically calculated monthly and reported by financial institutions.

Why is COFI important for ARMs?

COFI provides a stable and reflective benchmark for adjusting interest rates on ARMs, aligning them with the lender’s actual cost of funds.

How does COFI compare to LIBOR?

While both are benchmarks for interest rates, COFI is based on the cost of funds for specific financial institutions, whereas LIBOR reflects the rate at which banks lend to one another in the international market.

Summary

The Cost of Funds Index (COFI) is essential in the finance industry, particularly for products like adjustable-rate mortgages. It reflects the average cost of funds for financial institutions and serves as a pivotal index for adjusting interest rates in alignment with changes in funding costs. Understanding COFI’s calculation, applications, and implications can aid both lenders and borrowers in making informed decisions regarding mortgage products and other financial instruments.

References

• Federal Home Loan Bank of San Francisco. (n.d.). Cost of Funds Index (COFI). Retrieved from FHLBSF.
• Investopedia. (n.d.). Cost of Funds Index (COFI). Retrieved from Investopedia.