What is the net spread in interest rates?
The net spread in interest rates is the difference between the average yield that a financial institution receives on loans – and other interest-generating activities – and the average rate it pays on deposits and borrowings. The difference in interest rates is a key determinant of the profitability (or lack thereof) of a financial institution.
Key points to remember
- The net interest rate spread is the difference between the interest rate a bank pays to depositors and the interest rate it receives from loans to consumers.
- The net difference in interest rates is critical to the profitability of a bank.
- It may be helpful to think of the net interest rate as a profit margin.
Understanding the net interest rate spread
Lending institutions, such as commercial banks, receive interest income from several sources. Deposits (often called basic deposits) are a primary source, usually in the form of checking and savings accounts or certificates of deposit (CDs). These are often obtained at low rates. Banks also obtain funds through equity, wholesale deposits and debt issues. Banks provide a variety of loans – such as home mortgages, home equity loans, student loans, car loans, and credit card loans – which are offered at higher interest rates.
The main activity of a bank is to manage the gap between the interest rate on deposits it pays to consumers and the rate it receives from their loans. In other words, when the interest that a bank gets on loans is higher than the interest it pays on deposits, it generates income from the interest rate spread. Simply put, net interest rate spreads are like profit margins. The larger the spread, the more likely the financial institution will be profitable.
The federal funds rate (“fed”) is an important element in determining the net spread of interest rates.
Calculation of the net interest rate spread
Most commercial banks (such as savings and loans) generate their main source of profit through net interest rate spreads. For example, they can credit depositors with 1.25% on their money while issuing a mortgage to a home buyer charging 4.75%. In this case, the net interest rate spread would be 3.5%, net of fees or costs incurred by the bank to carry out the two transactions.
Net spread in interest rates and federal funds rates
Although we are not concerned with how rates are determined in the market, there are several factors that determine rates, including monetary policy set by the Federal Reserve Bank and yields on US treasury bills. While open market activities ultimately shape the net interest rate spread, the federal funds rate (“fed”) plays an important role in determining the rate at which an institution lends immediate funds. Indeed, according to the US Federal Reserve, the federal funds rate is “the interest rate at which deposit-taking institutions lend the balance of their reserves to other deposit-taking institutions overnight.”
This applies to the largest and most creditworthy institutions, as they keep the required amount of the required reserve. So the federal funds rate is a base interest rate, a rate by which all other interest rates in the United States are determined. The federal funds rate is a key indicator of the health of the US economy.