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Net Interest Rate Spread

The difference between the interest rate a financial institution pays to depositors and the interest rate it receives from loans

What is Net Interest Rate Spread?

Net interest rate spread refers to the difference between the interest rate a financial institution pays to depositors and the interest rate it receives from loans. In other words, it is the difference between the borrowing and lending interest rates of the bank. The interest rate spread is a key determinant of the financial institution’s profitability and is similar to a profit margin.

 

Net Interest Rate Spread

 

Summary

  •  The net interest rate spread refers to the difference in the borrowing and lending interest rates for banks and other financial institutions. It can be described as a determinant of profitability for the institution.
  • Typically, the interest paid out on deposits is at a lower rate than the interest the bank charges on loans, meaning that the bank generates income. Banks keep a close eye on the spread, because the greater the spread, the larger the income.
  • The net interest rate spread is reported by banks in their financial statements and is examined closely by investors and other interested parties.

 

A Detailed Explanation – How Do Banks Operate?

To better understand the net interest rate spread, we first must understand how financial institutions operate. The financial institutions referred to here are mostly banks. Banks issue a variety of loans to customers, which includes mortgages on a property, student loans, and auto loans. They charge interest on the loans.

Banks generate income through deposits in the form of savings and checking accounts, shareholder equity, or debt issuance and payout interest. Typically, the interest paid out on deposits is at a lower rate than the interest the bank charges on loans, meaning that the bank generates income.  As such, the larger the interest rate spread, the higher the income the bank earns.

For commercial banks, the income gained through interest rate spreads is their primary source of income. The calculation for interest rate spread is quite simple – it is the difference between the two interest rates mentioned above.

 

Net Interest Rate Spread - How Do Banks Operate

 

Practical Example

For example, Bank ABC charges customers 4% interest for car loans and pays out interest to depositors for holding their money at a rate of 1.75%. It means that the interest rate spread will be 4% – 1.75% = 2.25%.

 

Importance of the Net Interest Rate Spread

The net interest rate spread is especially important because it is essentially a measure of the profit margin for the institution. It is because the larger the spread, the more money the bank earns. Both rates can fluctuate over time, which means that the bank needs to keep a close eye on them to prevent a substantial decrease in income.

The net interest rate spread is reported by banks – and other publicly-traded corporations that are responsible to shareholders – as disclosure in their financial statements for quarterly and year-end fiscal reports. The spreads of different banks are closely examined by international organizations, such as the World Bank, which releases data from different countries around the world to provide users with information on the average lending and deposit rates worldwide.

For investments, the interest rate spread is used to evaluate the rates of investments versus the benchmark rates in a particular industry. It commonly occurs for securities and bonds. The spread rates are compared according to the credit rating and enable bonds of the same rating (such as AA or BB) to be compared against each other for more accurate results.

 

How Are Interest Rates Determined?

The interest rates themselves are a key determinant of the interest rate spread and are affected by several factors.  Government policy plays a key role in determining the interest rates, as do market transactions in the open market.

In the United States, the policy set by the Federal Reserve Bank leads to a federal funds rate, which helps determine the rate at which institutions lend funds. It is done to maintain the mandatory amount of reserve required, meaning that the federal funds rate acts as a base interest rate. The other interest rates build upon the base rate according to each institution.

 

Net Interest Rate Spread Software

Banks typically use special software to help them calculate the net interest rate spread and manage the spread strategically. Examples of such software include the following:

  • Margin Maximizer Suite: Originally developed by the US Banking Alliance, the software is installed onsite and uses a Microsoft Net-based application that must be installed on each user’s computer beforehand. It is also used in conjunction with an onsite consulting service.
  • PrecisionLender: The web-based program is delivered to users as a service (SaaS) program.
  • Austin Associates LLC: The program is catered more towards commercial loan pricing but is more traditional, as it uses HTML web forms.

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Annual Percentage Rate (APR)
  • Credit Spread
  • Spread Trading
  • Net Interest Rate Differential (NIRD)

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