Cost of Funds Index (COFI)

Cost of Funds Index (COFI) is a financial benchmark that reflects the interest expenses of a group of banks and savings institutions. Think of it as the average price these institutions pay to get the money they lend out—their 'cost of goods sold,' if you will. This money comes from various sources, like customer savings accounts, certificates of deposit (CDs), and other borrowings. Historically, the most famous version was the 11th District COFI, which tracked the costs for savings institutions in Arizona, California, and Nevada. Its primary claim to fame was its use as a reference rate for many Adjustable-Rate Mortgages (ARMs). When you have a COFI-based ARM, your mortgage interest rate isn't pulled out of thin air; it's calculated by taking the COFI and adding a fixed percentage called a margin. This index was popular because it was less volatile than many other benchmarks, offering a smoother ride for homeowners' monthly payments.

Imagine you're a baker. Your 'cost of funds' is what you pay for flour, sugar, and eggs. COFI is like an index tracking the average price of these ingredients for all the bakers in a specific region. For banks and S&Ls, their 'ingredients' are the deposits they take in and the money they borrow. The index calculates a weighted average of the interest rates paid on these funds. Because it's based on the interest paid on existing, often long-term, deposits and borrowings, COFI is known as a lagging indicator. It doesn’t react instantly to what the Federal Reserve does today; instead, it reflects the built-in, historical cost of money on the banks' books. This makes it move slowly and predictably, like a large ship changing course rather than a speedboat making a sharp turn.

If you ever had or considered an ARM from the 1980s through the 2000s, you likely encountered COFI. The appeal was its stability.

The interest rate on a COFI-based ARM is beautifully simple: Your Interest Rate = COFI + Margin. The COFI value changes periodically (e.g., monthly), while the margin is a fixed percentage set by the lender when you take out the loan. For example, if the current COFI is 3% and your margin is 2.5%, your mortgage rate is 5.5%.

COFI's sluggish nature is a double-edged sword for homeowners:

• Good News in a Rising Rate World: When interest rates across the economy are shooting up, your COFI-based ARM will rise much more slowly. Your payments remain lower for longer compared to loans tied to more volatile indices like the old LIBOR.
• Bad News in a Falling Rate World: When the Fed slashes rates, you'll be staring enviously at your friends with other types of ARMs. Your COFI-linked rate will drift downwards at a snail's pace, meaning you won't benefit from the lower rates as quickly.

While COFI is most famous in the world of home loans, a savvy value investor can glean useful insights from understanding it.

For a bank, profit often comes down to its Net Interest Margin—the difference between the interest it earns on loans and the interest it pays on deposits and borrowings. A bank's cost of funds is a huge factor here. While specific COFI indices are less common now, the underlying concept is critical. When analyzing a bank's financial health, a value investor must investigate its cost of funds. If this cost is rising sharply, it can squeeze the bank's NIM and signal potential trouble, unless the bank can effectively pass that higher cost on to its borrowers.

The financial world has largely moved on from indices like the 11th District COFI and LIBOR. Newer benchmarks, such as the SOFR, are now the standard. For an investor, this highlights a crucial lesson: the rules of the game can change. Understanding the benchmarks that underpin financial products—whether it's a mortgage, a corporate bond, or a complex derivative—is not just academic. It's fundamental to assessing risk and understanding how an asset's value and cash flows are determined. Always read the fine print!