What is 'Cost Of Funds'
Cost of funds is the interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one of the most important input costs for a financial institution, since a lower cost will generate better returns when the funds are deployed in the form of short-term and long-term loans to borrowers. The spread between the cost of funds and the interest rate charged to borrowers represents one of the main sources of profit for most financial institutions.
BREAKING DOWN 'Cost Of Funds'
For lenders such as banks and credit unions, cost of funds is determined by the interest rate paid to depositors on financial products including savings accounts and time deposits. Although the term cost of funds usually refers to financial institutions, most corporations that rely on borrowing are impacted by the costs they must incur to gain access to capital.
Cost of Funds Basics
Cost of funds and net interest spread are conceptually the most basic way banks make money. Banks make money through the interest rates they charge on loans as well as debt securities they own and other equity products that consumers, companies and large-scale institutions need. The interest rate banks charge on such loans must be greater than that of the interest rate they pay for the use of funds – the ‘cost of funds’ – which banks obtain from a variety of different sources.
These sources of funds that cost banks money fall into a number of categories. Deposits are the primary source of funds, with most people choosing to deposit their money in a bank, which the bank pays interest on the deposit, and in return uses that money for its own revenue-generating operations. Often called core deposits, these funds are typically checking or savings accounts and are obtained at generally low rates. Banks also obtain funds through shareholder equity, wholesale deposits, and debt issuance.
In certain cases, there is public information about the cost of funds for certain financial institutions. The 11th District Cost of Funds Index is a monthly weighted average of the cost of funds for banks operating in Arizona, California and Nevada. It primarily measures the interest rates banks pay for checking and savings accounts.
Banks then make money by charging interest on loans that is higher than the initial cost of funds amount. There are many different kinds of loans that banks issue, and consumer lending comprises the largest amount of lending in the United States. Mortgages on property, home equity lending, student loans, car loans and credit card lending are all such loans that banks offer at variable, adjustable or fixed interest rates.
The difference between the average yield of interest obtained from loans and the average rate of interest paid for deposits and other such funds (or the cost of funds) is called the net interest spread, and it is an indicator of a financial institution’s profit. Akin to a profit margin, the greater the spread the more profit the bank realizes. Conversely, the lower the spread the less profitable the bank.
Cost of Funds in a Wider Context
The relationship between cost of funds and interest rates is fundamental to understanding the U.S. economy. There are a number of ways interest rates are determined. While open market activities shape interest rates at which financial institutions lend money, and by extension make money that surpasses the initial cost of funds, the federal funds rate also plays a key role. The federal funds rate is “the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.” It only applies to the biggest, most credit-worthy institutions as they lend and borrow overnight Federal Reserve funds amongst each other to maintain the mandated amount of reserve required.
Thus, the fed funds rate is a base interest rate by which all other interest rates in the U.S. can be determined. It is both an indicator of how well the economy is doing as much as it is a determiner of interest rates, whether for the bank or the consumer. The Federal Reserve’s Federal Open Market Committee (FOMC) regulates the reserve’s monetary policy, and as such issues a desired target rate that responds to economic conditions in order to maintain a healthy economy.
For instance, during a period of rampant inflation in the early 80s, the fed funds rate soared to 20%. In the wake of the Great Recession starting in 2007 and the ensuing global financial crisis, as well as European sovereign debt crisis, the FOMC maintained a record low target interest rate of 0% to 0.25% in order to boost the U.S. economy and encourage economic growth. As the U.S. economy has recovered over the years, the Federal Reserve is currently readying to increase the fed funds rate at the end of 2015 or in 2016. There has been wide speculation about the potentially negative consequences of such a rate hike.