People often think of the cost of funds in terms of how much their small businesses will pay out in order to obtain a loan or line of credit. In financing terms, however, the cost of funds is something else entirely. But, it still impacts how much your business pays for financing, and knowing the right terms can help avoid unnecessary confusion as you explore your small business funding options.
Below, we’ll break down some of the most common “cost of” terminology, explain what cost of funds really is, and answer the following questions:
- How do we calculate the cost of funding on a bank’s total borrowing and/or lending?
- How do I calculate the average cost of funds for banks?
What is the Cost of Funds?
Simply put, cost of funds references the interest a financial institution pays to obtain the capital it uses to operate.
Cost of Funds Description
In order to understand what the cost of funds is, it’s helpful to go back to the source. Financial institutions don’t generally have piles of their own money lying around waiting for people to borrow it. Instead, the money they loan is entrusted to them by their customers. For example, a customer may open a bank account and deposit money into a savings account or set up a time deposit, such as a CD. These are known as fund sources. In any of these cases, the financial institution pays the customer a certain amount for the privilege of taking their deposit.
How the Cost of Funds Are Determined
Continuing with the same examples, a financial institution might pay something like .07 percent as an annual cost to a customer with a savings account or around 0.25 percent for a one-year CD. That is the cost of funds.
Naturally, the financial institution wants there to be a large spread between the cost of funds and the interest charges for borrowers. It’s one of the ways the institution makes profit. Ergo, the lower the cost of funds, and the higher the interest rate the institution charges, the better it is for their business.
What is the Cost of Funds Index?
Also known as the COFI, the cost of funds index is weighted average of interest rates a financial institution pays to borrow money. A financial institution may calculate the COFI at various levels, such as regional or federal, to help determine how much to charge when it loans the money out.
One example of this is the Federal COFI, published each month by Freddie Mac. It uses marketable Treasury bills and notes in its calculation. These sources of debt had a cost of funds index of over one percent in a recent calculation, but they climbed well over four percent prior to the 2008 economic crisis.
What is the Cost of Capital?
Unlike cost of funds, which relates to the financial institution’s expenses, cost of capital relates to the cost to finance a business. Organizations use it to determine whether it’s fiscally smart to embark on a new project.
Cost of Capital Formula
A business owner has two main options when they require capital: equity and debt. With equity financing, the company raises money through selling shares. Investors receive payment for owning shares. The loan amount owed is referred to as the cost of equity.
With debt financing, the company raises money by borrowing and, of course, financial institutions charge interest. The amount owed in this case is referred to as the cost of debt.
Businesses leverage both types of financing, so to get a clearer picture of whether a project will be profitable, they’ll calculate the weighted average of all their financing sources—both equity sources and debt sources. This is known as the weighted average cost of capital or WACC.
If the cost of capital is less than the business anticipates earning on its new venture, it’s a good investment. If the cost of capital is more than the anticipated profit, it’s a bad investment that can reflect a negative profit margin and the organization shouldn’t be raising capital to fund it.
What Do Similar “Cost Of” Terms Mean?
Throughout this page, a multitude of “cost of” terms have been used. A quick recap of their definitions is below.
Defining “Cost Of” Terms
1. Cost of Capital
The cost of capital is a term that businesses use in relation to how much it costs to obtain funding.
2. Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the weighted average of all a business’ financing sources, including equity and debt financing.
3. Cost of Borrowing
The cost of borrowing relates to the amount paid to borrow funds. It can be expressed in interest payments, fees, or other charges.
4. Cost of Debt
The cost of debt refers to the amount a business pays to borrow capital.
5. Cost of Equity (COE)
The cost of equity (COE) refers to the amount a business pays to its shareholders.
6. Cost of Funds
The cost of funds relates to the amount a financial institution pays in order to obtain the capital required to operate.
7. Cost of Funds Index (COFI)
The cost of funds index (COFI) is weighted average of interest rates a financial institution pays to borrow money.
Get the Funding Your Business Needs Through Invoice Factoring
Both equity financing and debt financing have their drawbacks. For example, debt financing always leaves you with more to pay back than you’ve borrowed and a huge part of that relates to how much the bank is paying to get the money for you. Equity financing can be even more costly and requires that you give up some degree of control of your company.
There is an alternative though. Invoice factoring allows you to tap into your unpaid B2B invoices and improve cash flow instantly. There’s no debt to pay back because you’re essentially selling your invoices and you aren’t tethered to shareholders like you would be with equity financing. To find out your factoring rate, get a free quote from Charter Capital.
- Tips on Valuing a Small Business When Buying or Selling - August 20, 2021
- What Are Liens and How Do They Work? - July 23, 2021
- 6 Business Growth Strategies for Successful Small Businesses - June 25, 2021