What Is Cost of Funds?

Cost of funds is a reference to the interest rate paid by financial institutions for the funds that they use in their business. The cost of funds is one of the most important input costs for a financial institution since a lower cost will end up generating better returns when the funds are used for 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 many financial institutions.

[Important: The cost of funds shows how much interest rates banks and other financial institutions must pay in order to acquire funds.]

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Cost of Funds

Understanding the Cost of Funds

For lenders, such as banks and credit unions, the cost of funds is determined by the interest rate paid to depositors on financial products, including savings accounts and time deposits. Although the term is often used with regard to financial institutions, most corporations are also significantly impacted by the cost of funds when borrowing.

Cost of funds and net interest spread are conceptually key ways in which many banks make money. Commercial banks charge interest rates on loans and other products that consumers, companies, and large-scale institutions need. The interest rate banks charge on such loans must be greater than the interest rate they pay to obtain the funds initially—the cost of funds.

How the Cost of Funds Are Determined

Sources of funds that cost banks money fall into several categories. Deposits (often called core deposits) are a primary source, typically in the form of checking or savings accounts, and are generally obtained at low rates.

Banks also gain funds through shareholder equity, wholesale deposits, and debt issuance. Banks issue a variety of loans, with consumer lending comprising the lion's share in the United States. Mortgages on property, home equity lending, student loans, car loans, and credit card lending can be offered 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.

Special Considerations

The relationship between the cost of funds and interest rates is fundamental to understanding the U.S. economy. Interest rates are determined in a number of ways. While open market activities play a key role, so does the federal funds rate (or “fed fund rate”). According to the U.S. Federal Reserve, the federal funds rate is “the interest rate at which depository institutions lend reserve balances to other depository institutions overnight.” This applies to the biggest, most credit-worthy institutions as they 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. are determined. It is a key indicator of the health of the U.S. economy. The Federal Reserve’s Federal Open Market Committee (FOMC) issues the desired target rate in response to economic conditions as part of its monetary policy 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 the European sovereign debt crisis, the FOMC maintained a record low target interest rate of 0% to 0.25% in order to encourage growth.

Key Takeaways

  • The cost of funds is how much banks and other financial institutions must pay in order to acquire funds.
  • A lower cost of funds means a bank will see better returns when the funds are used for loans to borrowers.
  • The difference between the cost of funds and the interest rate charged to borrowers is one of the main sources of profit for many financial institutions.