Cost of Funds

Cost of funds is what a financial institution pays to obtain the money it puts to work. For a bank, it is the interest paid to depositors and to lenders in the money and bond markets, expressed as an annual rate on the funds raised. It is the main input cost of lending: a bank earns a profit when the yield on its loans and investments exceeds what it pays for funding, after allowing for operating costs and credit losses.

The concept applies beyond banks. Non-bank lenders, card issuers, instalment payment providers and payment companies that advance money to customers all have a cost of funds, whether they borrow from banks, sell their receivables or use shareholders' capital. It is narrower than cost of capital, which also includes the return required by equity investors.

The standard calculation is:

Here interest expense is the total interest paid on deposits and borrowings during the period, and the denominator is the average balance of those liabilities over the same period. A bank that paid 30 million in interest during a year on average interest-bearing liabilities of 1.2 billion has a cost of funds of 2.5%.

Analysts often use a broader version that adds non-interest-bearing deposits to the denominator, since these balances also fund the bank and cost nothing in interest. A bank with a large base of such deposits reports a lower figure on this measure.

The level of the cost depends on the mix of funding.

• Transaction deposits. Balances in current and checking accounts, known as demand deposits, pay little or no interest. They are the cheapest source, though they carry the operating cost of branches, payments and service.
• Savings and time deposits. Savings accounts and certificates of deposit pay rates that follow the market more closely.
• Wholesale funding. Borrowing from other banks, large institutional deposits, repurchase agreements and bonds, together called wholesale funding, is priced off market benchmarks plus a spread for the borrower's credit risk.
• Central bank facilities. Borrowing from the central bank is available against collateral at rates set by policy.
• Securitization and credit lines. Non-bank lenders usually fund themselves by borrowing against pools of loans or selling them to investors.

The dominant influence is the central bank's policy interest rate, which anchors short-term market rates such as the federal funds rate and SOFR in the United States. When policy rates rise, wholesale funding reprices almost at once, while deposit rates follow more slowly and only in part. The share of a change in market rates that a bank passes on to depositors is its deposit beta; a low beta means cheap, stable funding.

Other factors are the institution's credit standing, which determines the spread it pays in wholesale markets, competition for deposits, the willingness of customers to move money in search of higher rates, and regulation. Liquidity rules favour stable retail deposits and longer-term funding, which can cost more than short-term borrowing.

The difference between the yield on assets and the cost of funds determines net interest income and, relative to assets, the net interest margin. Lenders set loan rates by starting from their funding cost and adding margins for operating expenses, expected losses, capital and profit.

Inside a bank, funds transfer pricing assigns an internal cost to every loan and an internal credit to every deposit, based on market rates for the relevant maturity. This lets management see whether a product or branch is profitable in its own right, separately from the bank's overall interest rate position. Some loan contracts refer directly to the lender's cost of funds, and published cost of funds indices have been used as benchmarks for adjustable-rate mortgages.

Payment businesses meet the concept wherever money is advanced before it is received. A card issuer funds cardholders' purchases from the date it settles with the network until the cardholder pays the statement. An acquirer or payment facilitator that pays merchants before receiving settlement, or a marketplace offering an instant payout, finances the gap. A buy now, pay later provider pays the merchant at once and collects from the shopper over weeks, so its margin depends heavily on what it pays for funding. Money transfer companies that practise prefunding, placing money with payout partners in advance, bear the cost of capital tied up in those balances.

The reverse also occurs. A firm that holds customer balances and earns interest on the float, such as a wallet provider or a stablecoin issuer, has in effect very cheap funding, and its income rises and falls with market interest rates.

An average cost of funds looks backward and blends liabilities raised at different times. For pricing new business, the relevant figure is the marginal cost: what the next unit of funding would cost today. The two diverge when rates are changing quickly. The measure also ignores non-interest costs of raising deposits, such as branches, marketing and deposit insurance premiums, and it says nothing about the stability of the funding. Cheap deposits that can leave within days proved a weakness for several United States regional banks that failed in 2023.