The net interest rate spread is the difference between what a bank pays on deposits and what it charges on loans. It’s an important financial metric for banks because it provides an indication of how healthy and profitable a bank is.
Here’s a closer look at what the net interest rate spread is, including how it works, how it’s calculated, and more about the factors that can affect it.
Definition and Examples of Net Interest Rate Spread
The net interest rate spread measures the difference between what a bank earns in interest on its assets (i.e. mortgages, loans, and other investment-related securities) and what it pays out to depositors or other creditors (i.e. the cost of funds).
Think of the net interest rate spread as a profit margin. It’s used to determine how well a bank is managing its assets and liabilities, as well as how profitable it is.
Net interest rate spread varies from bank to bank. The average global net interest rate spread was 5.3% in 2018. This means the difference between what a bank earns on loans and what it pays on deposits was 5.3% on average around the world. Average net interest rate spreads vary widely from country to country.
Typically, the wider the spread, the more money a bank is bringing in for shareholders and investors.
How Net Interest Rate Spread Works
To understand how net interest rate spread works, you must first understand how banks make money. Banks earn a significant amount of their income by charging more in interest on loans than they pay to customers on deposits. Let’s take Bank of America, for example.
In 2020, Bank of America made $2.3 trillion on interest-earning assets, with an average yield of 2.25%. It spent $1.6 trillion on interest-bearing liabilities, with an average yield of 0.5%. This means its net interest rate spread was 1.75%, or $700 billion, for its lending activities.
In other words, that year, the annual percentage rate (APR) Bank of America charged on mortgages, credit cards, leasing, and other types of loans was 1.75% higher on average than the annual percentage yield (APY) it paid out on savings accounts, money market accounts, certificates of deposit, and IRAs.
Of course, financial institutions are complex organizations and there are many factors that can determine their profitability, such as their investment policies or ability to attract and retain customers. Still, the net interest rate spread provides a general idea of the profitability and efficiency of the institution.
How To Calculate the Net Interest Rate Spread
The net interest rate spread formula is pretty straightforward. It’s simply the difference between a bank’s interest rate on loans and its interest rate on deposits. The formula looks like this:
Net interest rate spread = (Interest earned on loans - Interest earned on deposits)
So if a bank’s average APR (i.e. its lending rate) is 3% and its average APY (i.e. its deposit rate) is 0.8%, then its net interest rate spread is 2.2%.
How the Federal Reserve Influences the Net Interest Rate Spread
All of this talk about net interest rate spreads may have you wondering how banks set interest rates in the first place. If they could make more money by raising rates, wouldn’t every bank try to increase their profitability by raising rates as much as possible?
Several factors influence a bank’s net interest rate spread. One of the biggest factors is government policy set by the Federal Reserve.
The Federal Reserve lowered the target range for the federal funds rate to 0%-0.25% in 2020 to help lower costs for borrowers during the COVID-19 pandemic.
There are several ways the Federal Reserve can manipulate interest rates: through open market operations, by adjusting reserve requirements, or by changing the federal funds rate.
The federal funds rate in particular is one of the most influential interest rates in the world. It determines several types of things in the U.S. economy, including prime rates and general interest rates on loans, the value of the U.S. dollar, a household’s or business’s spending habits, and more. It also acts as the base interest rate for institutions.
- The net interest rate spread is the difference between what a bank pays on deposits and what it charges on loans.
- The net interest rate spread is similar to a profit margin in that the wider it is, the more profitable and competitive a bank is believed to be.
- Several factors can influence a bank’s net interest rate spread, including the federal funds rate, reserve requirements, and open market operations.