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COFI loans and negative amortization

When interest rates move higher, it can cause many borrowers to look for loans that offer an alternative to higher-priced fixed-rate mortgages. Until recently, adjustable-rate mortgages (ARMs) have provided a viable alternative. ARMs could save a homebuyer a significant amount of money at least for the first several years, compared to fixed rates.

This has created a void for borrowers seeking a lower rate and payment for the first few years. Jumping back on the scene in an attempt to fill the void is the cost of funds index or COFI loan. This type of mortgage isn’t new but it has been gaining popularity recently. COFI loans offer a low introductory interest rate, tempting many borrowers to climb aboard. Unfortunately, the details hidden in the fine print can really hurt you. In many cases, borrowers do not realize or are not told about the many risks found in this program that can far outweigh the advantages.

COFI loans have a very low starting rate, but typically only for the first one to three months. The loan can then increase to as high as 12 or 13 percent. After the initial one or three months the rate adjusts monthly. In a sense, that makes it 12 times riskier than the standard one-year ARM that can change once a year.

COFI loans give clients a false sense of security because the payment changes annually. Each year the monthly payment can only increases by 7.5 percent of the previous year’s monthly payment.

This is where confusion sets in.

While the payment remains the same for the first year and can only increase gradually each year thereafter, the actual interest rate can climb significantly higher. There is an important difference between the amount of the payment and the amount being charged as a result of the actual interest rate. If the rate of interest is higher than the amount being paid in the monthly payment (this is usually the case with COFI loans for the first few years) the difference is added to the principal balance.

This is known as negative amortization. Someone borrowing 200,000 and conscientiously making their monthly mortgage payments for two years, could find their mortgage debt has swelled to $215,000 rather than reducing it to $197,000. To rub salt in the wound even deeper, the borrower pays additional interest on the differential.

It’s as if you are treating your home like a credit card. That’s a bad thing to do with the roof over your family’s head.

How does a borrower ever get off this merry-go-round? Remember that annual payment cap of 7.5 percent of the previous year’s payment? Payments can keep escalating until they reach a level when the mortgage is paid off in 30 years. This can create tremendous hardship for many borrowers.

Some borrowers may be told that they can avoid negative amortization by paying their mortgage on a bi-weekly basis. The problem here is that the bi-weekly payment plan translates into one additional mortgage payment per year. That is an added expense that defeats the purpose of taking on the riskier COFI loan in the first place. Bi-weekly payment plans can be an excellent option but it would work much better with a program that does not have the potential for negative amortization.

Negative amortization can be more harmful than you think. Not only does your personal balance sheet look worse but try and sell your home when the mortgage balance is higher than the price you can get for your home. The COFI mortgage with negative amortization can become a trap for borrowers who find that they can’t refinance to a lower rate because the balance of the mortgage exceeds the acceptable loan to value ratios for refinance transactions. In some cases, while there may be an availability to refinance, borrowers still may have to pay an extra mortgage insurance fee.

Often times the cost of funds index may be sold or publicized as an index that is less volatile than ARMs pegged to one-year Treasury bill yields (the normal structure for most ARMs) because it lags behind the one-year Treasury bill. This is another reason to steer clear of COFIs. If interest rates have risen significantly they may now be peaking. Therefore, the index on the COFI loan will probably continue to rise long after interest rates on other mortgages decline.

Consumers should think long and hard before taking on a COFI mortgage or any mortgage that has the potential for negative amortization. These types of loans have also taken on different names like COSI, perhaps as a disguise. This is why borrowers should always ask if there is the possibility of negative amortization.

This article is based on information and research from articles written by Barry Habib