If Rates Decline, Deposit Costs Must Decline. Right? Nope.

Many banking executives might believe that near-zero interest rates are normal. They also might believe a return to near-zero rates would mean a return to large deposit volumes at low costs.

Unfortunately, while history often repeats itself, it sometimes doesn’t. In the case of rates, a decline to near zero—or even a rate decline of two hundred basis points—will likely sustain competitive pressure on deposits rather than diminish it.

Why would deposit pressure continue if rates declined?

It’s banks’ loan-to-deposit ratios, which are down significantly. Banking institutions have the capacity to lend right now. And, large numbers of consumers and businesses have the capacity to borrow. Ask anyone at a bank or credit union; they know a business, a friend, or a family member waiting on lower rates to finance something: Business expansion, a new kitchen, or a new home.

Rates have made borrowing expensive this year. But if it were cheap – historically cheap – again, institutions will see loan demand. And deposits fund loans.

Bank Loan-to-Deposit Ratios at a 15-Year Low

Since the 2008 financial crisis, the loan-to-deposit ratio of all banks has declined from 91.6% in the second quarter of 2008 to 64.2% in the same quarter in 2024. Credit unions’ loans-to-shares ratio is at 84% as of the second quarter and has steadily risen since 2011. (2011 is the earliest data available from the National Credit Union Administration.)

“During the pandemic, bank deposit ratios bottomed out at 56%. We’ve seen loan growth go up since then, but we’re nowhere close to what the industry has had in the past,” Neil Stanley, Founder and CEO of The CorePoint, told The Financial Brand.

All community institution executives should consider the loan-to-deposits ratio of the nation’s largest banks. Those over $250 billion in assets have the reach, technology, and deposit pricing to gather funds when needed.

What does this all mean for deposit competition and banking institutions’ cost of funds?

“It means cost of funds won’t just automatically decline if Fed Funds goes down,” Stanley observes. “If loan demand goes up, cost of funds may not respond as the industry expects. It could mean more deposit competition and pricing pressure, and not a return to the 2021 conditions many anticipate.”

If loan demand could cause rising cost of funds, let’s look at the indicators for increased loan demand in a low-rate environment.

Will Lower Rates Result in More Demand for Consumer Credit?

Homeowners have never had more equity than they do right now, according to the St. Louis Federal Reserve. The average borrower sits on roughly $214,000 in “tappable” equity. That means the average homeowner could borrow that amount, secure it with their home, and remain within the 20% equity cushion most lenders require.

“Persistent home price growth has continued to fuel home equity gains for existing homeowners who now average about $315,000 in equity and almost $129,000 more than at the onset of the pandemic,” said Dr. Selma Hepp, chief economist for CoreLogic.

Alongside the equity trend is the rise in mortgage-free home ownership. According to the latest data from the U.S. Census Bureau, the ratio of mortgage-free homes has risen every year since 2010. For single-family, condos, and townhomes, 61% are mortgaged. The other 39% are owned free and clear of a mortgage, according to analysis of the latest data by The Financial Brand.

Americans have the financial strength to borrow, even if a recession reduces the price of their homes. Many are waiting for nearly free borrowing rates to invest in their homes or second properties.

Dig deeper:

Will Lower Rates Result in More Demand for Commercial Credit?

The U.S. continues to face severe housing shortages. The National Association of REALTORS recently reported the United States needs about 5.5 million more housing units.

“The imbalance between supply and demand has contributed to a huge run-up in home prices in recent years, although pricing has started to stabilize—and even decline—in some markets,” says a report from NAR and Rosen Consulting. “Access to affordable housing has huge implications for real estate investors, economic growth, healthy communities and the need for people to live somewhere.”

The United States has been running a housing deficit since the Great Recession. What changed to slow construction of multifamily housing? “Higher interest rates and ballooning construction costs are complicating calls for more multifamily units,” NAR says.

In a scenario where inflation has cooled, and rates decline, both conditions slowing the rate of multifamily construction will dissipate. And people continue to need a place to live.

Will Rising Demand for Mortgages Affect Cost of Funds?

Banks don’t fund mortgages with deposits, as they do for commercial or consumer loans. People who buy homes, however, tend to borrow more when they buy a house, especially within the first year. When rates decline, mortgages and home buying are likely to respond. With that comes borrowing to upgrade those homes.

A 2022 study by the National Association of Home Builders found that new homebuyers spend four times more on outdoor patios, walks, fences, pools, and driveways than those who have not recently purchased a home.

“During the first year after closing, new home buyers spend close to $12,000 on [alterations and repairs generally], while buyers of existing homes average less than half of that amount ($5,760),” the association reported. “Non-moving owners spend even less on property alterations and repairs – under $3,000 in a typical year.”

Not all of the purchases made in that first year are discretionary, either. Home Innovation Research Labs also found that “two thirds of new single-family detached homes built in 2019 came with no clothes dryers,” NAHB reported. Lawnmowers also topped the list of purchases when people acquired a new home—they may not have had a yard to mow before.

Considering that nearly half of Americans (44%) say they could not pay for a $1,000 emergency expense with savings, where will the funds come from for a new washer and dryer? Debt is the most likely answer.

With loan demand ready to surge, bank and credit union executives must consider a scenario very different from the one currently anticipated. Future profitability won’t be driven solely by lower rates because banking has always been a game heavily influenced by competitors’ behavior. What if those competitors need funding more than they do now?

Moreover, significantly lower rates incentivize loan refinancing across loan types, perhaps even more so from those large commercial clients. Institutions will need more deposits for new credit just as those borrowers in the loan portfolio are increasingly incentivized to refinance. Together, these circumstances spell even more pressure on deposits – loan refinancing will create a greater need for lower-cost funding just as loan growth sustains deposit competition across the industry.