RateWatch #402 – Some Choices with Loan Types

April 10, 2004 by Dick Lepre

What's Happening

The technicals are threatening another bearish move (higher rates).  This could result from an unexpectedly high CPI this coming week.

Some Choices with Loan Types

I had several conversations with borrowers this past week which reminded me that there are certain types of loans for special situations.

In addition to fixed rate fully amortized loans there are three other loan types which may be appropriate to certain situations.  These are: intermediate term ARM's, interest only loans and negative amortization loans.

Greenspan recently suggested that many folks would be better off with ARM's rather than fixed rate loans.

I answered a question on this topic with this:

"I always address the issue of ARM v. fixed by looking at the difference in expense over, say, 5 years.  The question comes down to a simple proposition which reads something like this: 'Does is make sense to spend $20,000 more over the next 5 years (on a fixed rate) to assure yourself that the rate is, say, 5.75% for the next 25 years?'

For the borrower, that is the proposition not 'what is Mr. Greenspan thinking?'  For some folks, particularly those who are staying in their house "forever" a fixed might make sense, for others, an ARM is the correct choice.  It is about cost, risk and peace of mind."

If you are fairly certain that you will be moving in 5 years and selling your home why get a fixed rate?

Interest Only

This is a simplification but I see interest only loans as being for young folks who are buying  expensive to very expensive homes and want a reasonable payment until their income(s) rise.  If you are buying a $1.25 million house and carrying a $1 million mortgage you may want to consider
"interest only."  This may get you into a "dream house" but, if you are going to stay in it you will have to refinance or start paying the principal off at some point.  The ideal situation is that of young folks with rising incomes (perhaps doctors who are just getting started professionally) who will be able to afford the fully amortized loan later but only the interest now.

Negative Amortization Loans

Negative amortization loans have payments that, essentially, are less than interest only loans.  A "negative amortization" loan may start less than 2% and have an initial payment of $1,000.
Even though the interest rate might adjust after 1 month you may be able to keep the start payment for an entire year. Your loan balance will go up if you choose to make the minimal payment. The minimum payment will go up by 7.5% from year to year. Depending on the loan program the "negative amortization" feature will cease when your loan balance reaches between 110% to 120% of the original loan amount. The "negative amortization" does not extend the life of the loan.

A common reason for getting these and using the negative amortization feature is to use the cash freed up each month to buy investment property and perhaps carry the negative cash-flow from the rental. The intent is to gain from appreciation in the value of the rental and perhaps sell the investment property at a gain. This may be an inherently riskier thing than a 30-year fixed
but it can also be the path to wealth.  The key thing is buying wisely.

There are several parameters regarding variable rate loans:

The first is the Index (these are described extensively below). The Index is related to the cost to the lender. Different lender's have different costs of funds and thus use different indices.

The start rate is the initial interest rate. It may last for 3 months, 6 months, 1 year, or as long as 7
years. The longer the initial period the higher the rate.

The margin is what is added to the value of the Index at the time of adjustment. The result is generally rounded to the nearest 0.125%.

The term cap describes how much the rate can go up or down when it adjusts. This is more important for volatile indices. Generally, the limit is 1% every 6 months (if the loan adjusts every 6 months) or 2% a year if it adjusts once a year.

The life cap, or ceiling, is the highest interest rate that the loan can have during its entire life.

Definition of Common Adjustable Rate Indices

COFI or 11th District Cost of Funds.

PROPER NAME: Monthly Weighted Average Cost of Funds for 11th District SAIF-Insured Institutions. This index, used primarily for ARM's with monthly interest rate adjustments, is calculated by the Federal Home Loan Bank of San Francisco. The 11th District represents the SAIF-insured savings institutions (savings & loan associations and savings banks) in Arizona, California and Nevada.

The cost of funds reflects the interest rates paid by institutions for savings accounts, FHLB advances, money borrowed from commercial banks, and other sources.

Since the largest part of a cost of funds index is interest paid on savings accounts, this index
lags behind the economy. As a result, ARM’s tied to this index rise (and fall) more slowly than
rates in general. However, such ARM’s often have payment caps, but no month-to-month interest rate caps.

This index is available by calling (415) 616-2600. The value changes once a month and is published at 3 P.M. on the last day of each month.

Some general information of COFI loans may be found on the Federal Home Loan Bank of San Francisco site: http://www.frbsf.org/

A history of the COFI index in table form is there as well.

1 Year T-Bill

PROPER NAME: Yield on Treasury Security Adjusted to a Constant Maturity of One Year. The One-Year Treasury Security index (or "T-Sec") is associated with ARM’s that feature annual rate adjustments. It is calculated by the Federal Reserve Board and has both a weekly and monthly value; most lenders use the weekly value. This index reflects the state of the economy and responds quickly to economic changes.

Confusion can arise when some lenders use the term "one year Treasury bill." Most one-year ARM’s -- but not all -- are tied to the Constant Maturity of the One Year Treasury Security.


Stands for London InterBank Offered Rate. It is a measure of commercial lending rates of a group of London banks. It is similar to the Prime rate. It moves up and down rapidly. It can best be obtained daily from the Wall Street Journal.

6 Mos. CD

This is a measure of what banks are paying on 6 month certificates of deposit. It moves less
rapidly than LIBOR or T-bill but more rapidly than COFI. This index is not as commonly used now as it was 5-10 years ago.

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