Cost of Funds

Your grandmother gives you $500 on your birthday. Since you’re her special, thrifty little fella or lady, you put that cash into a savings account that pays you 2% a year. Assuming you don’t touch that money, you’ll have $510 at the end of the year (thanks, Federal Reserve) due to interest.

That $10 you earned in interest is an expense to the bank. An expense called “cost of funds.”

Add up all the interest paid by a bank for the money that they pay to depositors on different accounts, and you receive an aggregate cost of funds for the entire financial institution.

Cost of funds is a key expense on which investors and companies measure the performance of a bank. Banks make money on loans to customers and business. Banks charge them interest for that capital. So if the bank loans out $400 and charges 5% to its customer (keeping $100 in reserves), it will effectively earn $22.50 in charges if the lendee doesn’t pay back any of the principal.

In this case, the bank lent money out and earned $22.50, but paid you $10 in interest. The $12.50 difference is known as the net interest spread. That amount is money that the bank could generate thanks to its deposit and lending operations.

See: WACC.