What does "cost of funds" refer to?

"Cost of funds" refers specifically to the dollar cost of interest paid on borrowed funds. This concept is crucial in the financial industry because it helps institutions understand the expense incurred when seeking external financing. For banks and financial entities, this cost represents the interest rates paid to depositors or on borrowed capital, which directly influences lending rates to consumers and businesses.

Understanding the cost of funds is essential for managing profitability and making informed decisions about interest rates on loans. When banks determine the rates they will offer to their customers, they consider their cost of funds to ensure they maintain healthy profit margins. This aspect of financial management directly impacts overall business operations, influencing how competitively they can price their lending products.

In contrast, expense categories like staff salaries, purchasing goods for resale, or operational expenses broadly encompass different aspects of a bank's financial situation but do not specifically address the interest costs associated with borrowed funds. "Cost of funds" focuses narrowly on the expense incurred directly from obtaining financial capital, making it a critical concept for effective financial analysis within the banking sector.