What is cost of funds and how does it differ from cost of deposits?

Cost of funds measures the interest rate a bank pays on all its borrowed money, including both customer deposits and other borrowings. Cost of deposits is narrower and only measures what the bank pays on deposit accounts. Because deposits are just one source of bank funding, cost of deposits is always a subset of cost of funds.

Both metrics measure what a bank pays for its money, but they cover different ground. Cost of deposits looks only at what the bank pays on customer deposit accounts. Cost of funds casts a wider net, covering deposits plus every other source of borrowed money. Because deposits are just one piece of a bank's total funding, cost of deposits is always a subset of cost of funds.

How Each Is Calculated

Cost of deposits equals total interest expense on deposits divided by average deposits over the period. Only deposit accounts factor in: checking, savings, money market accounts, and certificates of deposit (CDs). Some analysts use average interest-bearing deposits as the denominator, excluding non-interest-bearing accounts from the calculation.

Cost of funds equals total interest expense divided by average total interest-bearing liabilities. This includes everything in cost of deposits plus all other borrowings: Federal Home Loan Bank (FHLB) advances, federal funds purchased, repurchase agreements, subordinated debt, and any other interest-bearing obligations. Both metrics are expressed as annualized percentages.

A Side-by-Side Example

Consider a bank with $8 billion in average deposits, $1.5 billion in FHLB advances, and $500 million in subordinated debt. It pays $160 million in deposit interest and $95 million in interest on its borrowings.

Cost of deposits: $160 million / $8 billion = 2.00%

Cost of funds: $255 million / $10 billion = 2.55%

The 55-basis-point gap tells you that this bank's non-deposit funding costs considerably more than its deposit base. If the bank could replace those borrowings with deposits at its current deposit cost, it would save $55 million in annual interest expense.

What the Gap Between Them Reveals

When cost of funds and cost of deposits sit close together, it usually means the bank funds itself almost entirely through deposits, with little reliance on outside borrowings. Most community banks fall into this category, with the gap typically under 10 to 15 basis points.

A wider gap signals meaningful dependence on non-deposit funding. That is not automatically a problem. Larger banks routinely access wholesale markets to manage liquidity and match the duration of their assets. But the premium a bank pays above its deposit cost for this additional funding eats directly into net interest margin. The wider the gap, the more the bank's profitability depends on earning a spread that covers its more expensive borrowed funds.

Watch for a gap that is widening over time. If cost of funds is climbing faster than cost of deposits, the bank is either taking on more wholesale funding or the cost of that funding is increasing, and both deserve closer examination.

How This Differs Across Bank Types

For community banks under $10 billion in assets, deposits typically make up 85% to 95% of total funding. Cost of funds and cost of deposits are usually within a few basis points of each other. The deposit franchise is the whole funding story, and cost of deposits is often the more useful metric to track.

Regional and larger banks tend to maintain a more diversified funding stack. FHLB advances, repurchase agreements, and capital market issuances supplement the deposit base. For these banks, cost of funds is the more complete measure because it captures the blended cost of all funding sources. Comparing cost of funds across large banks that use very different funding mixes is more meaningful than comparing cost of deposits alone.

When to Focus on Each Metric

Cost of deposits is the better metric for evaluating the strength of a bank's deposit franchise in isolation. Comparing cost of deposits across peer banks shows you which banks have stickier, lower-cost customer relationships, bigger non-interest-bearing deposit bases, or better pricing discipline.

Cost of funds matters more when you are connecting funding costs to profitability. The spread between a bank's yield on earning assets and its cost of funds is closely related to net interest margin (NIM). Two banks can have identical deposit costs, but the one funding 15% of its balance sheet with expensive FHLB advances will show a meaningfully higher cost of funds and a thinner margin.

During periods when interest rates are rising, both metrics tend to climb, but not always at the same speed. Deposit costs may lag as banks delay repricing savings and checking accounts, while wholesale funding reprices immediately at market rates. This can cause the gap between the two metrics to temporarily widen, compressing margins even when deposit costs appear stable.