What it means
Ask a bank what its money costs and there are two answers. The average cost of funds blends every deposit and borrowing on the books; the marginal cost of funds is the price of the next dollar raised, and it is the number that decides whether the next loan makes money.
The two diverge exactly when it matters. In rising-rate markets, new funding costs more than the old book, so a loan priced off the average looks profitable while actually lending below the cost of its own funding, a silent loss scaled with every origination.
Banks manage the gap through funds transfer pricing, the internal system that charges business units the marginal cost of their funding and credits them for the funding they raise. Regulators actively supervise this machinery: interagency guidance on funds transfer pricing addresses exactly these marginal funding costs and their risks.
The marginal cost moves with market structure. When deposits are plentiful, the next dollar is nearly free; when competition for funding bites, the bank must raise deposit rates or tap wholesale markets, and the marginal cost jumps ahead of anything the average admits.
For borrowers, the concept explains pricing behaviour. Your rate is not the bank's average cost plus margin; it is the marginal cost of funding your loan today plus margin, which is why loan offers reprice faster than the bank's blended funding costs.
For depositors, the same logic sets what banks will pay. When a bank needs marginal funding, deposit rates rise even if its existing book was raised cheaply, and rate shoppers are really competing to be the bank's next dollar.
For bank managers, confusing average with marginal is the classic profitability error. Growth funded at rising marginal costs can shrink margin even as the balance sheet balloons, a trap that only marginal-cost discipline catches in time.
The durable takeaway: the marginal cost of funds is the price of the next dollar, and it, not the average, should price the next loan. Watch it when rates move, because it leads every lending decision and every deposit offer the bank makes.
In practice
Real-world examples.
Example
A bank's average funding costs 2.1 percent, but new term deposits cost 3.4; pricing new loans off the average would lend below true funding cost on every deal written this quarter.
Example
A deposit-rate war breaks out locally; the bank's marginal funding cost jumps 80 basis points in a month, and its loan repricing follows within weeks while the average cost barely twitches.
Example
A treasury unit's transfer-pricing report shows the lending desk earning under its marginal funding charge; the desk's celebrated loan growth was destroying margin, visible only at the margin.
Formula
Calculation
Marginal cost of funds = incremental cost of the next unit of funding (new deposit rate or wholesale borrowing cost); lending test: loan yield > marginal funding cost + operating cost + risk charge + target margin.
Worked example. An invented bank funds $90 million at an average cost of 3% and raises a further $10 million of wholesale funding at 5%. It assumes an operating cost of 1.0%, a risk charge of 0.8% and a target margin of 1.0% on the loan.
- Average cost of funds = (90 x 3% + 10 x 5%) / 100 = (2.7 + 0.5) / 100 = 3.2%; marginal cost of funds = 5%.
- Priced off the average, the loan yield would be 3.2% + 1.0% + 0.8% + 1.0% = 6.0%. Priced off the margin, the test requires 5.0% + 1.0% + 0.8% + 1.0% = 7.8%.
- On a $1,000,000 loan at 6.0%, the bank earns 6.0% - 5.0% - 1.0% - 0.8% = -0.8% before any target margin, a loss of $8,000 a year, and it falls $18,000 short of the 7.8% required (1.8% x $1,000,000).Case study
Seen in the real world.
Fictional example: Meridian Bank, a fictional regional lender, wins market share through a lending surge its CEO celebrates at every town hall. Its new CFO rebuilds pricing around marginal funding costs: the bank's wholesale borrowing for the growth costs 4.9% while the loan book's blended funding assumption sits at 3.1%. Deal-by-deal analysis shows a third of the surge lent below full marginal cost. Pricing resets, growth halves, and margin recovers within a year.
The board's lesson enters the policy manual: growth is bought at the margin, and anyone reporting average costs to justify new lending has answered the wrong question beautifully. Meridian's treasury team now publishes a weekly marginal funding sheet beside the average-cost report, and loan officers quote from the first. The change is cultural as much as technical: relationship managers who once defended thin spreads now ask what the next dollar costs before agreeing a rate. Meridian and its figures are invented for illustration.
Watch out
Common mistakes.
- Pricing loans off average funding costs. In moving markets the average lags reality; the marginal cost decides whether the next loan earns, and regulators supervise transfer pricing for exactly this reason.
- Celebrating growth without the funding bill. Balance-sheet expansion at rising marginal costs can shrink net interest margin while the loan totals look triumphant.
- Ignoring wholesale dependence. Funding growth from markets rather than deposits raises and destabilizes the marginal cost, adding rate and rollover risk the average conceals.
Questions
People also ask.
What is the marginal cost of funds?
The cost of a bank's next dollar of funding: the newest deposit rate or wholesale borrowing cost, as distinct from the average cost of its whole funding base.
Why does it matter more than the average?
Because new loans are funded at the margin. Pricing off the average in a rising market lends below true cost, which is why regulators' funds-transfer-pricing guidance centres on marginal funding.
How does it affect borrowers and depositors?
Loan offers reprice with the bank's marginal funding cost, and deposit rates rise when banks compete for marginal funding, so both customers meet the marginal figure before the average moves.
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