If your mortgage is an ARM that adjusts with the Cost of Funds Index (COFI) then you need to know about this little publicized jump in interest rates.  And even if you don’t have an ARM, this could affect you as well.

A borrower’s worst nightmare — a sudden increase in the index on which adjustable rate mortgages (ARMs) are based — took place without much notice at 3pm local time on December 31.

An increase in the cost of funds index (COFI) published by the Federal Home Loan Bank of San Francisco from 1.259% to 2.094% was published on the bank’s website at 3pm PST.  For a $250,000 ARM it could raise monthly payments more than $100 in 2010.

The drastic increase — 0.835% on a base of 1.259% is a 66% increase — had more to do with the way the index is created than with underlying economic factors.  When Wachovia was acquired by Wells Fargo it was dropped from the banks which comprise the index.  It had been the largest bank included in the COFI and its cost of funds was among the lowest.  So the index’s numerator — banks’ average cost of funds — went up and its denominator — total deposits — went down.  The sudden rise — if it stands — will affect borrowers nationwide but especially west of the Mississippi.

COFI and the six month London Interbank Offered Rate (LIBOR) are the two indices that affect most ARMs.  LIBOR remained steady in December and is now almost 1.5% below COFI. LIBOR is the more widespread of the two indices. So it depends on which index your ARM is based but at 1.5% the difference between the two is dramatic.

If your loan is tied to COFI rather than LIBOR and its rate is, for instance, 2.5% above COFI then your rate increase would be 22% — up from 3.759% to 4.594%

If the increase stands the housing market could be in for a rude shock in 2010.  Will it stand? The Obama administration is committed to stimulating home sales and the unique reasons behind this unusual increase could provide grounds for it to pressure lenders tied to COFI to get more realistic. If it doesn’t then lenders who are tied to LIBOR may not idly watch their competitors reap a windfall; they may find ways to match the rise in rates.  Absent pressure to force the COFI index down, it could spread.