What it means
Every lender runs two books at once. On one side sit earning assets such as mortgages, business loans, credit card balances and investment securities that generate interest income; on the other sit deposits, wholesale funding and bonds that cost interest expense.
The difference between the two is net interest income, and for most traditional banks it represents the majority of total revenue. Fees, commissions and trading gains matter, but they usually sit alongside net interest income rather than replacing it.
Three things move the number: volume, price and mix. Volume is how much has been lent, price is the average rate earned and paid, and mix is the balance between high-yield lending such as unsecured credit and low-yield assets such as government securities.
Interest rate risk sits underneath all of this. A lender whose loans reprice quickly but whose deposits do not will see net interest income rise when rates go up, while one funded by rate-sensitive savings accounts and holding long fixed-rate mortgages can be squeezed hard in exactly the same conditions.
It is worth keeping the term separate from net interest margin, which is the same idea expressed as a percentage of earning assets. Net interest income is a dollar amount and grows simply by getting bigger, whereas the margin measures how profitably each dollar of assets is being used.
In practice
Real-world examples.
Example
A credit union earns $12,000,000 of interest on car and home loans and pays $3,500,000 to savers, giving net interest income of $8,500,000. That amount has to cover branch costs, staff, loan losses and any surplus returned to members.
Example
A consumer lender funded by wholesale borrowing sees its funding cost rise by 1.5% while competition prevents it from repricing its loan book. Net interest income falls sharply even though the number of loans outstanding is unchanged.
Example
A bank treasury team presents quarterly net interest income to the board alongside modelling of a 100 basis point rate shock, showing how much the figure would move if rates rose or fell across the whole curve.
Formula
Calculation
Net Interest Income = Interest Income Earned - Interest Expense Paid
A community bank holds an average loan book of $500,000,000 through the year at an average yield of 6.4%, producing interest income of 0.064 x $500,000,000 = $32,000,000.
It funds that lending mainly with customer deposits averaging $420,000,000 at an average cost of 1.5%, producing interest expense of 0.015 x $420,000,000 = $6,300,000.
Net interest income is therefore $32,000,000 - $6,300,000 = $25,700,000.
Now suppose competition for savings pushes the average cost of deposits to 2.0%. Interest expense rises to 0.020 x $420,000,000 = $8,400,000 and net interest income falls to $32,000,000 - $8,400,000 = $23,600,000, a reduction of $2,100,000 without a single loan changing hands.Case study
Seen in the real world.
Harbourgate Savings Bank is a fictional institution and this example is illustrative only. It began a rate cycle with average earning assets of $800,000,000 yielding 5.5%, giving interest income of $44,000,000, and deposits of $650,000,000 costing 1.2%, giving interest expense of $7,800,000. Net interest income was $44,000,000 - $7,800,000 = $36,200,000.
Rates then rose quickly. Because most of Harbourgate's lending was long-dated and fixed, the average asset yield crept up only to 5.7%, lifting interest income to $45,600,000. Savers, however, moved money fast, and the average cost of deposits jumped to 2.4%, lifting interest expense to $15,600,000. Net interest income collapsed to $30,000,000, a fall of $6,200,000 in a single year.
Management responded by writing new lending on variable rates, offering fixed-term deposits to lock in funding for longer, and hedging part of the fixed-rate book. The bank could not undo the loans it had already written, but it changed the shape of the balance sheet so that the next rate move would not hurt as much.
Watch out
Common mistakes.
- Treating net interest income as profit, when operating costs, loan loss provisions and tax all still have to be paid out of it.
- Assuming that rising interest rates automatically help every lender, which depends entirely on how quickly assets and liabilities reprice.
- Confusing net interest income with net interest margin, and so comparing a large bank's dollar figure with a small one's percentage.
Questions
People also ask.
Does net interest income include fees?
No, account fees, arrangement fees and commissions sit in non-interest income, although some upfront loan fees are spread over the loan's life and do form part of interest income.
What makes net interest income grow?
Lending more, widening the gap between what is charged and what is paid, or shifting the mix towards higher-yielding assets and cheaper deposits.
Is the concept relevant outside banking?
Yes, equipment leasing companies, consumer finance providers and insurers with large investment portfolios all analyse the same spread between what their assets earn and what their funding costs.
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