Cost of Funds: What It Is, How to Calculate, and its Effects
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Summary:
The cost of funds is a crucial aspect for financial institutions, representing the amount they spend to acquire money to lend to their customers. Typically sourced from Federal Reserve banks, the cost of funds directly impacts the interest rates charged to borrowers, affecting both banks and consumers. This article explores the concept of the cost of funds, its importance in the financial industry, and its relationship with the broader economy. Understanding how financial institutions manage these costs is key to comprehending the financial landscape.
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.
Understanding the cost of funds
Borrowing money costs money, both for individuals getting a mortgage and large banks 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 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.
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. The Federal Reserve announced it would raise interest rates after its FOMC meeting in March 2022 amid persistent, rising inflation. The rate increases continued, and as of June 2023, the target range stood at 5% to 5.25%.
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 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 equity to fund their operations and achieve their goals.
What is the fed funds rate and how does it affect the cost of funds?
The Federal Reserve Fed funds rate, also known as the “Fed funds rate,” is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. It is a base interest rate by which all other interest rates in the U.S. are determined, so the Fed funds rate shapes the interest rate banks charge on loans, as it must be greater than the interest rate they pay to obtain the funds initially, which is the cost of funds.
The bottom line
The cost of funds is how much money financial institutions must pay to obtain funds for reserves and lending. These funds are typically 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.
Frequently asked questions
How do you calculate the cost of funds?
To calculate the cost of funds, multiply the borrowed amount by the interest rate, then multiply by the time period.
Who pays the cost of funds?
Primarily, the cost of funds is paid by banks to the Federal Reserve when they borrow from the U.S. central bank. But most businesses and individuals that borrow also bear the burden of the cost of funds in the form of the interest rate spread they are required to cover for their lenders.
How do banks manage the cost of funds?
Banks manage the cost of funds by strategizing their borrowing practices, adjusting interest rates for loans and deposits, and diversifying funding sources.
Why is the cost of funds important for borrowers?
The cost of funds directly influences the interest rates borrowers pay for loans, impacting their financial obligations and the cost of borrowing.
What is the impact of the Fed funds rate on the cost of funds?
The Fed funds rate shapes the interest rates set by banks for lending, affecting the cost of funds and, subsequently, the borrowing costs for consumers and businesses.
Key takeaways
- The cost of funds refers to the expenses incurred by financial institutions to acquire money for lending.
- It significantly impacts interest rates, banking profitability, and borrowers’ cost of borrowing.
- The relationship between the cost of funds and interest rates is pivotal for the U.S. economy.
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