Net Interest Rate Spread

What is the 'Net Interest Rate Spread'

The net interest rate spread is the difference between the average yield a financial institution receives from loans, along with other interest-accruing activities; and the average 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).

BREAKING DOWN 'Net Interest Rate Spread'

In simple terms, the net interest spread is like a profit margin. The greater the spread, the more profitable the financial institution is likely to be; the lower the spread, the less profitable the institution is likely to be. While the federal funds rate plays a large role in determining the rate at which an institution lends immediate funds, open market activities ultimately shape the rate spread.

Loan-granting financial institutions, such as many commercial banks, receive interest income from a range of sources. Deposits (often called core deposits) are a primary source, generally in the forms of checking or savings accounts. These are often obtained at low rates. Banks also obtain funds through shareholder equity, wholesale deposits, and debt issuance. Banks issue a variety of loans, the lionshare of which consists of consumer lending in the United States. Mortgages on property, home equity lending, student loans, car loans and credit card lending can be offered at variable, adjustable or fixed interest rates.

Net Interest Spread and the Federal Funds Rate

As noted above, while open market activities are key to determining the net interest spread, the federal (“fed”) funds rate, is a core component. According to the U.S. Federal Reserve, the federal funds rate is “the interest rate at which depository institutions lend reserve balances to other depository institutions overnight.” This applies to the biggest, most credit-worthy institutions as they maintain the mandated amount of reserve required. Thus, the fed funds rate is a base interest rate, by which all other interest rates in the U.S. are determined. The fed funds rate is a key indicator of the health of the U.S. economy.