The cost of funds is the interest rate that banks and other financial institutions pay to use their customer's money. Banks must calculate their costs of funds as part of their accounting procedures. Borrowers and lenders calculate the cost of funds by taking the total annualized interest expense and dividing that total by the average interest bearing deposits and other interest-bearing borrowings.
Annualized Interest Expense
The annualized interest expense is the interest expense generated in a specific time period, prorated on an annual basis. For instance, if Generic Bank has interest expenses of $10 million per month, then Generic's annualized interest expense for the year would be $120 million. If Fictional Funds has interest expenses of $5 million per quarter, then Fictional's annualized interest expense for four quarters would be $20 million.
An interest-bearing deposit is any account with a financial institution that pays interest to the account holder. Savings accounts and certificates of deposit are among the most popular interest-bearing accounts. Most banks also offer checking accounts that function as interest-bearing deposits. The cost of funds formula uses the average of the interest-bearing accounts for the bank's reporting period. For example, if Fictional Funds had interest-bearing deposits of $100 million in the first quarter, $110 million in the second, $90 million in the third, and $100 million in the fourth, the average of interest-bearing deposits would be $100 million (100+110+90+100 = 400; 400/4 quarters = 100).
Calculating Cost of Funds
The cost of funds is the ratio between the annualized interest expense and the average interest-bearing deposits. The cost of funds represents the percentage of the interest-bearing deposits that the bank must pay out in interest. For Fictional Funds, the cost of funds would be the annualized interest expense of $20 million, divided by the average of interest-bearing deposits, which is $100 million. The cost of funds would be $20M/$100M, or 20 percent.
Cost of Funds Index
The cost of funds index, or COFI, is an average of interest expenses incurred by financial institutions within a specific region. Banks will use the COFI as a benchmark for calculating interest rates on variable rate loans, such as auto loans and home mortgages. These loans have their interest rates linked to a regional COFI specified in the loan agreement.