What it means
A bank takes deposits at one rate and lends at a higher rate. The gap between the two, after allowing for the volume of money involved, is the main source of its profit.
At the whole-bank level, the interest spread compares the average yield on all earning assets, such as loans and securities, with the average cost of all interest-bearing liabilities, such as deposits and borrowings. It is stated as a percentage.
It is related to, but different from, the net interest margin. The net interest margin divides net interest income by total earning assets, and is usually a little higher than the spread when the bank is also funded by money that costs nothing, such as shareholders' equity and non-interest-bearing current accounts.
Spreads change with the economy. When central bank rates rise, banks can often lift loan rates faster than deposit rates at first, widening the spread, but intense competition for deposits can squeeze it again.
A flat or inverted yield curve, where short-term rates are close to or above long-term rates, tends to compress the spread. Managers watch the spread closely because small changes have large effects on profit.
A bank with $10,000,000,000 of earning assets sees its income change by $10,000,000 for every 0.10% shift in the spread. The term is also used for individual products.
The spread on a mortgage, for example, is the difference between the rate the customer pays and the lender's cost of funds, and a customer can sometimes negotiate it down by showing a strong credit record.
In practice
Real-world examples
Example 1
A community bank offers savers 2% on deposits and lends to small businesses at 7%. The 5-point spread has to cover the bank's staff, premises, bad debts and profit. If staff and premises cost 3 points and bad debts 1 point, only about 1 point is left as profit.
Example 2
A credit card issuer reviews its profitability and finds that the spread between its card interest rates and its funding costs has narrowed. It decides to raise the rate on new customers with a weaker credit record.
Example 3
A corporate treasurer negotiates a loan and learns that the bank is pricing it at the benchmark rate plus a spread of 2.25%. She compares offers from three banks and uses the lowest spread to bargain with her main lender.
Think of it
Interest spread is like a corner shop buying crisps from a wholesaler for 50p per bag and selling them to customers for 1 pound. The 50p difference is the margin that keeps the shop in business, just as interest spread is the margin banks and businesses make on money.
Formula
Calculation
Interest spread = Average yield on earning assets - Average cost of interest-bearing liabilities
Net interest margin = Net interest income / Average earning assets
A bank has $200,000,000 of earning assets that yield 6.5%, so interest income is 200,000,000 x 0.065 = $13,000,000. It has $180,000,000 of interest-bearing liabilities costing 3.0%, so interest expense is 180,000,000 x 0.03 = $5,400,000. The interest spread is 6.5% - 3.0% = 3.5%. Net interest income is 13,000,000 - 5,400,000 = $7,600,000, so the net interest margin is 7,600,000 / 200,000,000 = 3.8%, which is higher than the spread because $20,000,000 of earning assets are funded by free money such as equity.Case study
Seen in the real world
Bayfield Credit Union is an illustrative, fictional lender with $400,000,000 of loans yielding an average of 5.8%. Its members' deposits cost an average of 2.8%, so the spread was 3.0%.
When rates rose, competing banks raised their savings rates, and members began moving money. Bayfield had to lift its deposit rate to 3.6% while loan yields rose only to 6.1%, narrowing the spread to 2.5%.
On $400,000,000 of assets, that 0.5-point squeeze cost about $2,000,000 a year in income. The fictional management team responded by repricing new loans, cutting costs and developing fee-based services, and the illustrative lesson is that spreads can shrink quickly when funding costs move faster than lending rates.
Watch out
Common mistakes
- Confusing the interest spread with the net interest margin, when the margin is based on net interest income and total earning assets.
- Assuming a wider spread is always better, when it may reflect riskier lending that will lead to higher losses later.
- Ignoring the cost of non-interest expenses and bad debts, which have to be covered by the spread before there is any profit, so a healthy spread alone does not guarantee a healthy bank.
Questions
People also ask
What is a good interest spread for a bank?
There is no single figure, because it varies with the type of lending, the competition and the interest rate cycle, so banks compare their spread with peers and with their own past results.
How is the interest spread different from a credit spread?
A credit spread is the extra yield a borrower pays over a risk-free rate, while the interest spread is the gap between what a lender earns and what it pays for funds.
Can a business use the interest spread idea?
Yes, any business that borrows to lend or invest, such as a leasing firm, can measure the gap between its yield and its cost of funds. A rising gap usually means better margins, while a falling one is an early warning.