Net Interest Rate Spread: Definition and Use in Profit Analysis

What Is the Net Interest Rate Spread?

The net interest rate spread is the difference between the yield that a financial institution receives from loans and other interest-accruing activities and the rate it pays on deposits and borrowings. The net interest rate spread is a key determinant of a financial institution’s profitability (or lack thereof).

Understanding the Net Interest Rate Spread

Loan-granting institutions, such as commercial banks, receive interest income from several sources. Deposits (often called core deposits) are a primary source, generally in the forms of checking and savings accounts or certificates of deposit (CDs). These are often obtained at low rates. Banks also obtain funds through shareholder equity, wholesale deposits, and debt issuance. Banks issue various loans—such as mortgages on property, home equity lending, student loans, car loans, and credit card lending—that are offered at higher interest rates.

The primary business of a bank is managing the spread between the interest rate on deposits that it pays consumers and the rate it receives from their loans. In other words, when the interest that a bank earns from loans is greater than the interest it pays on deposits, it generates income from the interest rate spread. In simple terms, net interest rates spreads are like profit margins.

The greater the spread, the more profitable the financial institution will likely be. However, this is just the basic view, and financial institutions work on creative customer acquisition, customer retention and loyalty, and principal investing strategies. Their individual strategies help them compete and differentiate themselves from other financial institutions.

Calculation of the Net Interest Rate Spread

To calculate an interest rate spread, you use the average rate of a bank's interest-bearing liabilities and the yield for its interest-earning assets. A formula might be:

I_i - I_o = Net Interest Rate Spread

Where:

• I_i is the interest rate the bank is paid, usually called interest-earning assets
• I_o is the interest rate the bank pays, usually called interest-bearing liabilities

For instance, in 2022, Capital One Financial Corporation (COF) had $31.24 billion in interest income with an average yield of 7.68%. Its interest-bearing liabilities for the year totaled $4.12 billion with an average yield of 1.25%. For 2022, the bank had an interest rate spread of 6.43%, or $27.1 billion, from its interest-bearing activities.

Net Interest Rate Spread vs. Net Interest Margin

Net interest margin is different because it accounts for other funding sources or income that don't fit a corporation's accounting definitions, such as investments or accounts that don't bear interest. For example, on its FY 2022 Annual Report, Capital One's net interest spread was 6.43%, but after accounting for the impact of 0.24% in non-interest-bearing funding, its net interest margin was 6.67%.

Its annual report doesn't explain what it considers non-interest-bearing funding, only that it has a "notional impact" that affects its net interest margin.

The Bottom Line

Net interest rate spread is one way banks measure their profitability. The measurement is a good indicator of a bank's financial performance for a period, but as with all metrics, it should be taken in context with other measures.