Reviewed by Sep 30, 2020| Updated on
The cost of funds is the interest rate that financial institutions are paying on the funds they use in their business. The cost of funding is one of the most significant input costs for a financial institution because a lower price would end up producing higher returns as the funding is used by borrowers for short-term and long-term loans.
One of the main sources of profit for several financial institutions is the spread between the cost of the funds and the interest rate charged to borrowers. The cost of funds demonstrates how much interest rate the banks and other financial institutions have to pay to acquire funds.
To borrowers such as banks and credit unions, the cost of the funds is dictated by the interest rate on financial products charged to depositors, including savings accounts and time deposits. While the term is mostly used with financial institutions, most companies are often greatly affected when borrowing the cost of the funds.
Funding costs and the distribution of net interest are conceptually important ways that banks can make money. Commercial banks are charging interest rates on loans and other products that consumers, businesses, and big institutions need. The interest rate charged by banks on these loans must be higher than the interest rate they pay for initially receiving the funds.
Fund sources which cost money to the banks fall into several categories. Deposits (often known as core deposits) are a primary source, usually in the form of savings accounts or checks, and are generally obtained at low rates.
Banks also raise funds through equity to shareholders, wholesale deposits, and debt issuance. Property mortgages, home equity loans, student loans, auto loans, and credit card loans can be offered at variable, adjustable, or fixed interest rates.