Cost of Funds: What It Is, How It Works, Why It's Important

What Is the Cost of Funds?

The term "cost of funds" refers to how much banks and financial institutions spend in order to acquire money to lend to their customers. Put simply, the cost of funds refers to the interest rate banks must pay when they borrow from a Federal Reserve bank. 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.

Lower cost of funds commonly generates better returns for banks when they are used for short-term and long-term loans to borrowers. Costs are passed on to borrowers, so when costs are high, borrowers must pay higher interest rates to access credit.

Understanding the Cost of Funds

Borrowing money costs money, both for individuals getting a mortgage and large bank granting that mortgage. For banks, the costs associated with borrowing are called the cost of funds.

In simpler terms, it's how much in interest a bank has to pay in order to borrow money to lend to its consumers. The cost of funds is paid by banks and other financial institutions to a Federal Reserve bank.

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. The term is often used and analyzed by the financial industry as a whole, so most corporations are also significantly affected by the cost of funds when borrowing.

Cost of funds and net interest spread are 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.

Why the Cost of Funds Is Important

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 (often called the fed funds rate).

According to the Fed, 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 seek to maintain the mandated amount of reserves required. Reserve requirements are limits set by the Federal Reserve that outline how much banks must hold in their vaults or at the nearest Federal Reserve bank in line with their deposits.

This means that 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 1980s, the Fed funds rate soared to 20%. In the wake of the Great Recession in 2007 and the ensuing global financial crisis (which led to the European sovereign debt crisis), the FOMC maintained a record low target interest rate of 0% to 0.25% to encourage growth.

How the Cost of Funds Is Determined

Sources of funds that financial institutions can access for a cost can fall into several categories. The primary source of funds is bank deposits, which are also called core deposits. These typically come in the form of checking or savings accounts, and are generally obtained at low rates. Other categories include:

• Shareholder equity
  
• Debt issuance
• Wholesale money, or cash that is found in money markets and lent by banks

Banks issue a variety of loans, with consumer lending comprising the lion's share in the U.S. 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.

Cost of Funds vs. Cost of Capital

Although they may seem the same, the cost of funds isn't the same as the cost of capital. Remember that the cost of funds refers to how much banks pay in order to acquire funds to lend to their customers. The cost of capital, though, is the total amount of money a business requires to get the money it needs for its operations.

When a business needs money (or its cost of capital), it can turn to one or more sources to raise the money. It can turn to a bank, from which it can lend capital. Some businesses also turn to their own equity to fund their operations and achieve their goals.

The Bottom Line

The cost of funds is how much money financial institutions must pay in order to obtain funds for reserves and lending. These funds normally borrowed from Federal Reserve banks. A lower cost of funds means a bank will earn better returns when the funds are used for loans to borrowers. In turn, consumers generally must pay more in interest when the cost of funds is higher.

It's important to understand that the difference between the cost of funds and the interest rate charged to borrowers is one of the main sources of profit for most banks.