What Is the 11th District Cost of Funds Index?

The 11th District Cost of Funds Index (COFI) is a monthly weighted average of the interest rates paid on checking and savings accounts offered by financial institutions operating in Arizona, California, and Nevada. It is one of many indices used by mortgage lenders to adjust the interest rate on adjustable rate mortgages (ARM) and was launched in 1981. With an ARM mortgage, the interest rate on a mortgage moves up and down along with some standard interest rate chosen by the lender, and COFI is one of the most popular indices in the western states.

Published on the last day of each month, the COFI represents the cost of funds for western savings institutions that are members of Federal Home Loan Bank of San Francisco, a self-regulatory agency, and satisfy the Bank’s criteria for inclusion in the index.

Understanding the 11th District COFI

The 11th District Cost of Funds Index (COFI) is computed using several different factors, with interest paid on savings accounts comprising the largest weighting in the average. As a result, the index tends to have low volatility and follow market interest rate changes somewhat slowly; it is generally regarded as a two-month lagging indicator of market interest rates. The interest rate on a mortgage will not match the COFI, rather the ARM rate is typically 2% to 3% higher than COFI, depending on the borrower’s credit history, the size and terms of the loan, the ability of the borrower to negotiate with the bank and many other factors.

Because it is computed using data from three western states, the COFI is primarily used in the western U.S., while the 1-year Treasury index is the measure of choice in the eastern region. On April 30, the Federal Home Loan Bank of San Francisco announced the COFI for March 2018 of 0.814%, slightly lower than February.

What Is an Adjustable-Rate Mortgage (ARM)?

The term adjustable-rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.

ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. The typical index that is used in ARMs has been the London Interbank Offered Rate (LIBOR).

Understanding Adjustable-Rate Mortgages (ARMs)

Mortgages allow homeowners to finance the purchase of a home or other piece of property. When you get a mortgage, you’ll need to repay the borrowed sum over a set number of years as well as pay the lender something extra to compensate them for their troubles and the likelihood that inflation will erode the value of the balance by the time the funds are reimbursed.

In most cases, you can choose the type of mortgage loan that best suits your needs. A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. As such, your payments remain the same. An ARM, where the rate fluctuates based on market conditions. This means that you benefit from falling rates and also run the risk if rates increase.

There are two different periods to an ARM. One is the fixed period and the other is the adjusted period. Here’s how the two differ:

• Fixed Period: The interest rate doesn’t change during this period. It can range anywhere between the first five, seven, or 10 years of the loan. This is commonly known as the intro or teaser rate.
• Adjusted Period: This is the point at which the rate changes. Changes are made during this period based on the underlying benchmark, which fluctuates based on market conditions.

Another key characteristic of ARMs is whether they are conforming or nonconforming loans. Conforming loans are those that meet the standards of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. They are packaged and sold off on the secondary market to investors. Nonconforming loans, on the other hand, aren’t up to the standards of these entities and aren’t sold as investments.

Rates are capped on ARMs. This means that there are limits on the highest possible rate a borrower must pay. Keep in mind, though, that your credit score plays an important role in determining how much you’ll pay. So, the better your score, the lower your rate.

Types of ARMs

ARMs generally come in three forms: Hybrid, interest-only (IO), and payment option. Here’s a quick breakdown of each.

Hybrid ARM

Hybrid ARMs offer a mix of a fixed- and adjustable-rate period. With this type of loan, the interest rate will be fixed at the beginning and then begin to float at a predetermined time.

This information is typically expressed in two numbers. In most cases, the first number indicates the length of time that the fixed rate is applied to the loan, while the second refers to the duration or adjustment frequency of the variable rate.

For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In comparison, a 5/1 ARM has a fixed rate for the first five years, followed by a variable rate that adjusts every year (as indicated by the number one after the slash). Likewise, a 5/5 ARM would start with a fixed rate for five years and then adjust every five years.

Interest-Only (I-O) ARM

It’s also possible to secure an interest-only (I-O) ARM, which essentially would mean only paying interest on the mortgage for a specific time frame—typically three to 10 years. Once this period expires, you are then required to pay both interest and the principal on the loan.

These types of plans appeal to those keen to spend less on their mortgage in the first few years so that they can free up funds for something else, such as purchasing furniture for their new home. Of course, this advantage comes at a cost: The longer the I-O period, the higher your payments will be when it ends.

Payment-Option ARM

A payment-option ARM is, as the name implies, an ARM with several payment options. These options typically include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest.

Opting to pay the minimum amount or just the interest might sound appealing. However, it’s worth remembering that you will have to pay the lender back everything by the date specified in the contract and that interest charges are higher when the principal isn’t getting paid off. If you persist with paying off little, then you’ll find your debt keeps growing—perhaps to unmanageable levels.

Advantages and Disadvantages of ARMs

Adjustable-rate mortgages come with many benefits and drawbacks. We’ve listed some of the most common ones below.

Advantages

The most obvious advantage is that a low rate, especially the intro or teaser rate, will save you money. Not only will your monthly payment be lower than most traditional fixed-rate mortgages, you may also be able to put more down toward your principal balance. Just ensure your lender doesn’t charge you a prepayment fee if you do.

ARMs are great for people who want to finance a short-term purchase, such as a starter home. Or you may want to borrow using an ARM to finance the purchase of a home that you intend to flip. This allows you to pay lower monthly payments until you decide to sell again.

More money in your pocket with an ARM also means you have more in your pocket to put toward savings or other goals, such as a vacation or a new car.

Unlike fixed-rate borrowers, you won’t have to make a trip to the bank or your lender to refinance when interest rates drop. That’s because you’re probably already getting the best deal available.

Disadvantages

One of the major cons of ARMs is that the interest rate will change. This means that if market conditions lead to a rate hike, you’ll end up spending more on your monthly mortgage payment. And that can put a dent in your monthly budget.

ARMs may offer you flexibility but they don’t provide you with any predictability as fixed-rate loans do. Borrowers with fixed-rate loans know what their payments will be throughout the life of the loan because the interest rate never changes. But because the rate changes with ARMs, you’ll have to keep juggling your budget with every rate change.

These mortgages can often be very complicated to understand, even for the most seasoned borrower. There are various features that come with these loans that you should be aware of before you sign your mortgage contracts, such as caps, indexes, and margins.

How the Variable Rate on ARMs Is Determined

At the end of the initial fixed-rate period, ARM interest rates will become variable (adjustable) and will fluctuate based on some reference interest rate (the ARM index) plus a set amount of interest above that index rate (the ARM margin). The ARM index is often a benchmark rate such as the prime rate, the LIBOR, the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries.

Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time that the interest rate adjusts, the rate falls to 4% based on the loan’s 2% margin.

Adjustable-Rate Mortgage vs. Fixed Interest Mortgage

Unlike ARMs, traditional or fixed-rate mortgages carry the same interest rate for the life of the loan, which might be 10, 20, 30, or more years. They generally have higher interest rates at the outset than ARMs, which can make ARMs more attractive and affordable, at least in the short term. However, fixed-rate loans provide the assurance that the borrower’s rate will never shoot up to a point where loan payments may become unmanageable.

With a fixed-rate mortgage, monthly payments remain the same, although the amounts that go to pay interest or principal will change over time, according to the loan’s amortization schedule.

If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate.

Is an ARM Right for You?

An ARM can be a smart financial choice if you are planning to keep the loan for a limited period of time and will be able to handle any rate increases in the meantime. Put simply, an adjustable-rate mortgage is well suited for the following types of borrowers:

• People who intend to hold the loan for a short period of time
• Individuals who expect to see a positive change in their income
• Anyone who can and will pay off the mortgage within a short time frame

In many cases, ARMs come with rate caps that limit how much the rate can rise at any given time or in total. Periodic rate caps limit how much the interest rate can change from one year to the next, while lifetime rate caps set limits on how much the interest rate can increase over the life of the loan.

Notably, some ARMs have payment caps that limit how much the monthly mortgage payment can increase, in dollar terms. That can lead to a problem called negative amortization if your monthly payments aren’t sufficient to cover the interest rate that your lender is changing. With negative amortization, the amount that you owe can continue to increase, even as you make the required monthly payments.

The Bottom Line

Borrowers have many options available to them when they want to finance the purchase of their home or another type of property. You can choose between a fixed-rate or adjustable-rate mortgage. While the former provides you with some predictability, ARMs offer lower interest rates for a certain period of time before they begin to fluctuate with market conditions. There are different types of ARMs to choose from and they have pros and cons. But keep in mind that these kinds of loans are better suited for certain kinds of borrowers, including those who intend to hold onto a property for the short term or if they intend to pay off the loan before the adjusted period begins. If you’re unsure, talk to a financial expert about your options.

What Is Annual Percentage Rate (APR)?

Annual percentage rate (APR) refers to the yearly interest generated by a sum that’s charged to borrowers or paid to investors. APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan or income earned on an investment. This includes any fees or additional costs associated with the transaction but does not take compounding into account. The APR provides consumers with a bottom-line number they can compare among lenders, credit cards, or investment products.

How the Annual Percentage Rate (APR) Works

An annual percentage rate is expressed as an interest rate. It calculates what percentage of the principal you’ll pay each year by taking things such as monthly payments and fees into account. APR is also the annual rate of interest paid on investments without accounting for the compounding of interest within that year.

The Truth in Lending Act (TILA) of 1968 mandates that lenders disclose the APR they charge to borrowers. Credit card companies are allowed to advertise interest rates on a monthly basis, but they must clearly report the APR to customers before they sign an agreement.

How Is APR Calculated?

APR is calculated by multiplying the periodic interest rate by the number of periods in a year in which it was applied. It does not indicate how many times the rate is actually applied to the balance.

$\begin{aligned} &\text{APR} = \left ( \left ( \frac{ \frac{ \text{Fees} + \text{Interest} }{ \text {Principal} } }{ n } \right ) \times 365 \right ) \times 100 \\ &\textbf{where:} \\ &\text{Interest} = \text{Total interest paid over life of the loan} \\ &\text{Principal} = \text{Loan amount} \\ &n = \text{Number of days in loan term} \\ \end{aligned}$​APR=((nPrincipalFees+Interest​​)×365)×100where:Interest=Total interest paid over life of the loanPrincipal=Loan amountn=Number of days in loan term​

Types of APRs

Credit card APRs vary based on the type of charge. The credit card issuer may charge one APR for purchases, another for cash advances, and yet another for balance transfers from another card. Issuers also charge high-rate penalty APRs to customers for late payments or violating other terms of the cardholder agreement. There’s also the introductory APR—a low or 0% rate—with which many credit card companies try to entice new customers to sign up for a card.

Bank loans generally come with either fixed or variable APRs. A fixed APR loan has an interest rate that is guaranteed not to change during the life of the loan or credit facility. A variable APR loan has an interest rate that may change at any time.

The APR borrowers are charged also depends on their credit. The rates offered to those with excellent credit are significantly lower than those offered to those with bad credit.

APR vs. Annual Percentage Yield (APY)

Though an APR only accounts for simple interest, the annual percentage yield (APY) takes compound interest into account. As a result, a loan’s APY is higher than its APR. The higher the interest rate—and to a lesser extent, the smaller the compounding periods—the greater the difference between the APR and APY.

Imagine that a loan’s APR is 12%, and the loan compounds once a month. If an individual borrows $10,000, their interest for one month is 1% of the balance, or $100. That effectively increases the balance to $10,100. The following month, 1% interest is assessed on this amount, and the interest payment is $101, slightly higher than it was the previous month. If you carry that balance for the year, your effective interest rate becomes 12.68%. APY includes these small shifts in interest expenses due to compounding, while APR does not.

Here’s another way to look at it. Say you compare an investment that pays 5% per year with one that pays 5% monthly. For the first month, the APY equals 5%, the same as the APR. But for the second, the APY is 5.12%, reflecting the monthly compounding.

Given that an APR and a different APY can represent the same interest rate on a loan or financial product, lenders often emphasize the more flattering number, which is why the Truth in Savings Act of 1991 mandated both APR and APY disclosure in ads, contracts, and agreements. A bank will advertise a savings account’s APY in a large font and its corresponding APR in a smaller one, given that the former features a superficially larger number. The opposite happens when the bank acts as the lender and tries to convince its borrowers that it’s charging a low rate. A great resource for comparing both APR and APY rates on a mortgage is a mortgage calculator.

APR vs. APY Example

Let’s say that XYZ Corp. offers a credit card that levies interest of 0.06273% daily. Multiply that by 365, and that’s 22.9% per year, which is the advertised APR. Now, if you were to charge a different $1,000 item to your card every day and waited until the day after the due date (when the issuer started levying interest) to start making payments, you’d owe $1,000.6273 for each thing you bought.

To calculate the APY or effective annual interest rate—the more typical term for credit cards—add one (that represents the principal) and take that number to the power of the number of compounding periods in a year; subtract one from the result to get the percentage:

$\begin{aligned} &\text{APY} = (1 + \text{Periodic Rate} ) ^ n – 1 \\ &\textbf{where:} \\ &n = \text{Number of compounding periods per year} \\ \end{aligned}$​APY=(1+Periodic Rate)n−1where:n=Number of compounding periods per year​

In this case your APY or EAR would be 25.7%:

$\begin{aligned} &( ( 1 + .0006273 ) ^ {365} ) – 1 = .257 \\ \end{aligned}$​((1+.0006273)365)−1=.257​

If you only carry a balance on your credit card for one month’s period, you will be charged the equivalent yearly rate of 22.9%. However, if you carry that balance for the year, your effective interest rate becomes 25.7% as a result of compounding each day.

APR vs. Nominal Interest Rate vs. Daily Periodic Rate

An APR tends to be higher than a loan’s nominal interest rate. That’s because the nominal interest rate doesn’t account for any other expense accrued by the borrower. The nominal rate may be lower on your mortgage if you don’t account for closing costs, insurance, and origination fees. If you end up rolling these into your mortgage, your mortgage balance increases, as does your APR.

The daily periodic rate, on the other hand, is the interest charged on a loan’s balance on a daily basis—the APR divided by 365. Lenders and credit card providers are allowed to represent APR on a monthly basis, though, as long as the full 12-month APR is listed somewhere before the agreement is signed.

Disadvantages of Annual Percentage Rate (APR)

The APR isn’t always an accurate reflection of the total cost of borrowing. In fact, it may understate the actual cost of a loan. That’s because the calculations assume long-term repayment schedules. The costs and fees are spread too thin with APR calculations for loans that are repaid faster or have shorter repayment periods. For instance, the average annual impact of mortgage closing costs is much smaller when those costs are assumed to have been spread over 30 years instead of seven to 10 years.

APR also runs into some trouble with adjustable-rate mortgages (ARMs). Estimates always assume a constant rate of interest, and even though APR takes rate caps into consideration, the final number is still based on fixed rates. Because the interest rate on an ARM will change when the fixed-rate period is over, APR estimates can severely understate the actual borrowing costs if mortgage rates rise in the future.

Mortgage APRs may or may not include other charges, such as appraisals, titles, credit reports, applications, life insurance, attorneys and notaries, and document preparation. There are other fees that are deliberately excluded, including late fees and other one-time fees.

All this may make it difficult to compare similar products because the fees included or excluded differ from institution to institution. In order to accurately compare multiple offers, a potential borrower must determine which of these fees are included and, to be thorough, calculate APR using the nominal interest rate and other cost information.

The Bottom Line

The APR is the basic theoretical cost or benefit of money loaned or borrowed. By calculating only the simple interest without periodic compounding, the APR gives borrowers and lenders a snapshot of how much interest they are earning or paying within a certain period of time. If someone is borrowing money, such as by using a credit card or applying for a mortgage, the APR can be misleading because it only presents the base number of what they are paying without taking time into the equation. Conversely, if someone is looking at the APR on a savings account, it doesn’t illustrate the full impact of interest earned over time.

APRs are often a selling point for different financial instruments, such as mortgages or credit cards. When choosing a tool with an APR, be careful to also take into account the APY because it will prove a more accurate number for what you will pay or earn over time. Though the formula for your APR may stay the same, different financial institutions will include different fees in the principal balance. Be aware of what is included in your APR when signing any agreement.