Included in the legal documents you will sign at settlement is a promissory note and a deed of trust (the mortgage). Both of these documents spell out the terms and conditions of your ARM loan. Here’s how they work:

Lets assume you are going to borrow $150,000 and will obtain a 5 year ARM. For the first five years, you loan payment will remain constant. However, 45 days before the end of the 5 year term, your lender will look at the interest rate for the index you have. There is also a margin -- ranging from 2.5 - 3.25 -- that the lender will add to your index. Your new rate will begin for one year at the interest rate at that time, plus the margin. However, most ARMs provide that your interest rate can not go up more than two percent on any adjustment period, and there is usually a lifetime (overall) cap, so that under no circumstances will your interest ever go more than 5 or 6 points above the initial rate.

Let’s be a little more specific. Today you start with an interest rate of 5 percent. Five years from now, the index is 8 percent. Your margin is 2.75. Without the cap, your new rate will be 10.75 (the 8 percent index plus the 2.75 margin). However, because there is a 2 percent adjustment cap, your new rate will be 7 percent.

Keep in mind that although the interest rate will be fixed during the initial ARM period, it will be adjusted on a yearly basis after the initial period is over. Now, let’s go back to the COFI loan. This stands for “Cost of Funds index”, and is determined and calculated every month by the Federal Home Loan Bank of San Francisco. According to the web site of that Bank:

The 11th District Monthly Weighted Average Cost of Funds Index (COFI) is one of many indices used by mortgage lenders to adjust the interest rate on adjustable rate mortgages. The monthly COFI reflects the actual interest expenses recognized during a given month by all savings institution members of the Federal Home Loan Bank of San Francisco (Bank).

It should be noted that the cost of funds index (COFI) is not an interest rate; it is an index.

Current and historical date on COFI can be found on the web site http://www.fhlbsf.com. My research -- going back over twenty years -- is that the COFI index has fluctuated from a high of 12.469 in November of 1981, to a low of 2.308 in January of 2003. However, throughout last year, the index remained relatively steady, ranging between 2.8 and 2.3. It is perhaps one of the least volatile of all of the indices used by mortgage lenders.

At first blush, a COFI loan is attractive. But as we all know, lenders do not give money away. Most COFI loans do not have caps, and thus if interest rates go up dramatically -- as they may do in the years to come -- your monthly mortgage payment will also go up.

Additionally, many COFI loan permit what is called “negative amortization”. In my opinion, such a program is not in the best interests of most consumers. What is this “negative amortization”? It works like this.

You are paying your monthly mortgage at a rate of 5 percent. But the lender has calcuated that your rate should really be 6 percent. Thus, each and every month that you make the regularly scheduled payment, your outstanding balance is increasing -- not decreasing -- by the difference between the 5 and the 6 percent. The difference is added to your loan balance. It is possible that when you ultimately go to sell your house, you will owe too much money, or if you want to refinance, you may not be able to get a new loan.

This is not an indictment against a COFI loan. It may be just the right approach for you. But there are many different kinds of loans, and you must comparison show, ask questions, and then sit down and “do the numbers” to see which loan is best for your pocketbook.