The cost of funds refers to the amount spent by a lending institution to acquire funds to lend to you. It essentially is the interest rate charged to obtain money, and is tied to the federal funds rate. Funds are obtained through customer deposits or other money markets.
The cost of funds affects customers who need financing. When the cost of funds increases for lending institutions, the cost to borrow money increases for you. This is why the cost of funds matters for your bottom line.
Definition and Examples of the Cost of Funds
The cost of funds is how much it will cost a lending institution to acquire funds it lends out to customers. Lending institutions often acquire this capital from one of the Federal Reserve banks. The amount a lending institution will pay for these funds is largely determined by the effective federal funds rate, which is a market rate influenced by the Federal Reserve through moves made to reach the federal funds target rate.
The Federal Open Market Committee meets eight times per year to evaluate the federal funds target rate. The federal funds rate influences the prime rate and longer-term interest rates for key financial instruments you have or will use, such as mortgages, auto loans, and savings accounts.
- Acronym: COF
The cost of funds is indexed (also known as the Cost of Funds Index or COFI) and published by Freddie Mac for each month. In October 2021, the COFI hit 0.752, which was the lowest since tracking began in 1976.
The cost-of-funds rate hit an all-time high of 13.610 in October 1981.
How Does the Cost of Funds Work?
Banks use the cost of funds to determine how much to charge their customers. The cost of funds isn’t a static number; it shifts based on the moves the Federal Reserve makes to regulate the economy, including buying or selling bonds to increase or decrease banks’ liquidity and changing the reserve requirement.
Banks don’t charge you the cost-of-funds rate. Rather, the rate you pay depends on how the bank prices its loans. For example, some banks may provide an interest rate based on the bank’s operating costs for servicing the loan, a risk premium, and profit margin on top of the cost of funds. This type of interest-rate calculation is called “cost-plus loan pricing.”
Other lenders may generate their interest rates using a “price leadership” model, in which the bank creates a prime rate that’s generally about 3% higher than a bank’s cost of funds rate. Banks tend to make their prime rate available to customers with the highest credit scores, as they present the lowest risk of default. For example, if the cost of funds for a bank is 2%, you can expect to pay, at best, around a 5% interest rate for your financing. If you have bad or average credit, you’ll likely end up with an interest rate that’s higher than the lowest rate the bank could charge you.
Cost of Funds vs. Cost of Capital
Cost of funds is not the same as the cost of capital. The cost of capital is the amount a business pays to obtain capital, whereas the cost of funds is how much a bank or lending institution pays to acquire funds. A business acquires capital from a bank, whereas a bank (or lending institution) acquires capital from Federal Reserve banks and customer deposits.
|Cost of Funds||Cost of Capital|
|How much a bank pays to obtain money||How much a business pays to obtain money|
|Obtained from Federal Reserve banks or customer deposits||Obtained from lending institutions, investors, shareholders, and other private lenders.|
|Tied to the federal funds rate||Different lending rates from the various lenders.|
|Loans provided to customer account for cost of funds as well as other factors such as credit risk, operating costs, and competitors’ rates||The minimum rate of return expressed as a percentage that a business must earn on a new investment|
- The rate at which lenders acquire funds affects how much they charge customers.
- Lower cost of funds for banks typically equals a lower cost of capital for the bank’s customers.
- Expect to see 3% added onto the bank’s cost of funds for prime-rate borrowers.
- Although the cost of funds is determined by the market, the Federal Reserve’s influence drives the federal funds rate that a bank pays to acquire funds to lend its customers.