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.
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.
