What is ‘Cost Of Funds’ & How do lenders set interest rates on loans?


Cost Of Funds:

Cost of funds is the interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one of the most important input costs for a financial institution, since a lower cost will generate better returns when the funds are deployed in the form of short-term and long-term loans to borrowers. The spread between the cost of funds and the interest rate charged to borrowers represents one of the main sources of profit for most financial institutions.


How do lenders set interest rates on loans?


For many borrowers, the factors that determine a bank’s interest rate are a mystery. How does a bank decide what rate of interest to charge? Why does it charge different interest rates to different customers? And why does the bank charge higher rates for some types of loans, like credit card loans, than for car loans or home mortgage loans?


Following is a discussion of the concepts lenders use to determine interest rates. It is important to note that many banks charge fees as well as interest to raise revenue, but for the purpose of our discussion, we will focus solely on interest and assume that the principles of pricing remain the same if the bank also charges fees.

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