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// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Cost of Funds: a Worked Example

The average is what the book cost; the next dollar, what it costs now.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED · 6 MIN READ

// THE SHORT ANSWER

Ask why a business loan quoted this month costs more than last month's, for the same borrower, and the answer is often the bank's cost of funds. A bank has two such figures. The average tells what its existing deposits and bonds cost. The marginal figure is the price of raising the next dollar, and that is the one new loans are priced from. In the example here, a rise in the bank's wholesale spreads lifts its average by 0.07 points and its marginal cost by 0.50 points, so new borrowers pay for a move that existing ones barely feel.

BASIS  Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

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PART OF How Banks Price a Business Loan

// 01 — WHAT A BANK PAYS FOR THE MONEY IT LENDS

A bank's funding comes from several places at different prices. Transaction and at-call accounts usually pay least. Term deposits pay more. Wholesale money, borrowed in the bank bill and bond markets, is priced off market benchmarks plus a spread that reflects how lenders view the bank. In Australia and New Zealand deposits supply the most: about two-thirds of the Australian major banks' non-equity funding in the Reserve Bank of Australia's March 2023 review and, counting retail deposits alone, often around 60% to 70% for New Zealand banks in a 2017 Financial Markets Authority paper.

A lender cares because funding comes before everything else in the price. A loan's margin has to pay for the funding above the base rate before it pays for losses, capital or staff. The bank's treasury usually charges the lending desk for this through funds transfer pricing, so the banker sees the cost as a transfer rate rather than a blend of deposits.

// 02 — AVERAGE COST AND MARGINAL COST

Average cost of funds = total interest paid on funding ÷ total funding
Marginal cost of funds = cost of raising the next dollar, for that term

The average looks back. It is what the balance sheet costs today, including bonds issued years ago and deposits that pay very little. The marginal figure looks forward, and it depends on the term: money raised for five years usually costs more than money raised for ninety days, because the bank is paying for the certainty of keeping it. Most banks price new loans on something close to the marginal figure, because that is what they must pay to fund them.

The two can separate sharply. In 2022, as the Australian cash rate rose, the cost of the major banks' outstanding funding climbed more slowly than the cash rate, partly because at-call deposits followed only in part and most of a move in bank bill rates takes three to six months to reach wholesale costs. New term deposits, by contrast, repriced further than the cash rate did.

// 03 — THE EXAMPLE

A bank funded with US$5.0bn of deposits and debt, constructed for this page like every figure on it, has this average cost. Amounts are in US$ millions, and the rates are the example's.

Source Amount Rate Annual cost
At-call and transaction 1,500 1.00% 15.0
Term deposits 2,000 4.00% 80.0
Short-term wholesale 500 4.60% 23.0
Long-term bonds 1,000 5.20% 52.0
Total 5,000 3.40% 170.0
New five-year money, swapped to floating: base 4.25% + 1.00% = 5.25%

Now the market demands 0.50 points more from this bank on new wholesale money. In the coming year only the short-term wholesale and the US$200m of bonds that mature reprice, each taken here as up 0.50 points for a full year. Term deposit rates are assumed to hold.

Extra cost: (500 + 200) × 0.50% = 3.5
New average: (170.0 + 3.5) ÷ 5,000 = 3.47% up 0.07 points
New marginal: 5.25% + 0.50% = 5.75% up 0.50 points
On a new US$3m five-year loan: 3m × 0.50% = US$15,000 a year

A borrower whose risk has not changed is quoted more, because the bank must raise new money at the new price. A second bank shows the other side. With the same total funding but far fewer deposits and more wholesale debt, its average is higher:

At call 500 at 1.00% = 5.0 Term 1,500 at 4.00% = 60.0
Short 1,000 at 4.60% = 46.0 Bonds 2,000 at 5.20% = 104.0
Total 215.0 ÷ 5,000 = 4.30%, or 0.90 points above the first bank

That difference is real, but it overstates the advantage: cheap deposits have to be gathered and serviced through branches, staff and systems, and the interest line does not show those costs.

// 04 — HOW IT DIFFERS FROM THE BASE RATE

The base rate on a floating loan is a market benchmark, and it is the same for every bank using it. Cost of funds is particular to one bank. New Zealand shows how loose the link can be: the same 2017 regulator's paper put bank bills, the market behind the BKBM benchmark, at only 1% to 2% of banks' total funding. A benchmark can set the price of a loan and still be a small part of what the lender pays.

It also differs from net interest margin, which is net interest income over earning assets. It is not the simple gap between the lending rate and the cost of funds: capital that pays no interest can widen it, and lower-yielding liquid assets narrow it.

DEFINED IN ONE PARAGRAPH → · FUNDS TRANSFER PRICING → · HOW BANKS WORK →

// 05 — WHERE IT DECIDES A FILE

On a new loan, cost of funds sets the floor, and it explains why a longer term usually costs more before anyone has looked at the borrower. On an existing committed loan the position is different: the margin generally stands for the term, so any rise on money the bank has to raise again falls on the bank until the loan rolls or refinances. That is one reason a facility coming up for renewal in a dearer funding market can be repriced with nothing wrong in the business.

It also shapes who can compete. A non-bank lender that borrows from investors at a higher rate needs a higher yield, and tends to win where speed or structure matters more than the rate. A borrower comparing offers learns more from the term, fees and conditions than from assuming the cheapest-funded lender will offer the lowest price.

BANK LOAN VS PRIVATE CREDIT → · CREDIT MARGIN →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

  1. Reserve Bank of Australia, Developments in Banks' Funding Costs and Lending Rates, Bulletin, March 2023 — Deposits are about two-thirds of major banks' non-equity funding; outstanding costs rose less than the cash rate in 2022 while new term deposit rates rose more — sections 01 and 02.
  2. Financial Markets Authority (New Zealand), Bank Bill Benchmark Rate and closing rates, October 2017 — page 2 — New Zealand banks' funding mainly comes from retail deposits, often 60% to 70%, and bank bills account for only 1% to 2% of total funding — sections 01 and 04.

// QUESTIONS PEOPLE ASK

How is a bank's cost of funds calculated?
The average is the total interest paid on deposits and borrowing, divided by the total of those balances, usually worked for each funding type and then weighted by size. A bank that pays 1% on a quarter of its funding and 5% on the rest has an average of 4%. The marginal cost is different: it is the price of raising new money today for a given term, which is what most banks use when pricing new loans.
Why does a central bank rate rise not reach cost of funds at once?
Because existing funding reprices on its own timetable. A term deposit pays its agreed rate until maturity, a bond pays its coupon unless it has been swapped, and at-call deposit rates may follow only part of the way. The new funding the bank raises reflects the higher rate immediately, so the marginal cost moves first and the average follows as the older funding rolls over. The speed depends on how much of the funding reprices each quarter.
Why do smaller lenders pay more for their funding?
Usually because they have a lower credit rating or none, so wholesale investors want a higher spread to lend to them, and a smaller deposit base means more of their money comes from those markets. Some smaller institutions offset this with local deposits. A higher cost of funds does not settle who offers the better loan, since a lender's overheads, capital position and appetite for the sector all feed the final price.
What does cost of funds plus margin mean in a loan agreement?
It means the interest is set from the lender's own funding cost rather than a published benchmark, with the margin added on top. Syndicated agreements have commonly kept it as a last-resort fallback where a term benchmark is unavailable or no longer reflects what lenders pay, though in compounded overnight-rate loans it is optional and often left out. A borrower should look at how the lender must show that cost, because the figure is the lender's own rather than one anyone can read on a screen.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

  • Treasury analystFunds the bank and manages the interest rate and liquidity risk created by its own balance sheet.
  • Product managerOwns what the bank sells rather than who it sells to — the design, pricing, terms and lifecycle of a lending, deposit or payments product.
  • Business relationship managerCarries a book of trading businesses — wins them, keeps them, and is the bank's voice when the answer is no.

THE IN-TRAY · ONE MINUTE

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A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE NUMBER · THE LOAN · PRICE

A company borrows at 8% a year. Its interest is deductible, and it pays tax at 25%.

What is its after-tax cost of this debt?

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5 MORE ON THE LOAN · PRICE →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHCost of funds What is a bank's cost of funds?