Glossary term
Cost of Funds
Cost of funds is the rate or expense a financial institution pays to obtain the money it lends or invests.
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What Is Cost of Funds?
Cost of funds is the rate or expense a financial institution pays to obtain the money it uses to make loans, buy assets, or run its balance sheet. For a bank, funding can come from deposits, wholesale borrowings, advances, brokered deposits, debt, or other sources.
The concept matters because lenders generally need to earn more on loans and investments than they pay for funding. The difference helps drive net interest margin, profitability, loan pricing, and credit availability.
Key Takeaways
- Cost of funds measures what a bank or lender pays for funding.
- Funding can come from deposits, borrowings, debt, and other sources.
- Higher funding costs can pressure margins and raise loan rates.
- Cost of funds is related to, but not the same as, a consumer's loan interest rate.
How Cost of Funds Works
A lender gathers funds and then deploys them into loans or securities. If deposit rates, market borrowing rates, or wholesale funding costs rise, the lender's cost of funds may rise. To protect profitability, the lender may raise loan rates, tighten credit standards, or change its funding mix.
Cost of funds can be measured at the institution level or through specific indexes. Some adjustable-rate mortgage products historically referenced cost-of-funds indexes, though many ARM products use other benchmarks.
Funding Sources and Effects
Funding source | How it can affect cost |
|---|---|
Customer deposits | Can be stable but may become more expensive when rates rise |
Brokered deposits | May help raise funds quickly but can cost more |
Wholesale borrowings | Can move with market rates and liquidity conditions |
Long-term debt | Can lock in funding but may carry higher fixed costs |
Federal Home Loan Bank advances | Can provide secured funding to member institutions |
Banking and Borrower Context
For banks, cost of funds is a core profitability input. A bank with low-cost stable deposits may have more flexibility than one that depends heavily on expensive short-term funding. During stress, funding costs can rise quickly and affect lending appetite.
For borrowers, cost of funds helps explain why loan rates do not move only because of credit risk. Funding markets, deposit competition, the yield curve, and bank balance-sheet strategy can all influence pricing.
The concept is also useful for reading bank earnings. Rising deposit costs can pressure profits even when loan balances are growing.
The Bottom Line
Cost of funds is what a lender pays to obtain the money it lends or invests. It affects bank profitability, loan pricing, and credit availability, especially when market rates or funding conditions change.