Net Interest Margin

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What is 'Net Interest Margin'

Net interest margin is a performance metric that examines how successful a firm's investment decisions are compared to its debt situations. A negative value denotes that the firm did not make an optimal decision, because interest expenses were greater than the amount of returns generated by investments.

It is calculated as:

Net Interest Margin

BREAKING DOWN 'Net Interest Margin'

For example, ABC Corp has a return on investment of $1,000,000, an interest expense of $2,000,000 and average earning assets of $10,000,000. ABC Corp's net interest margin would be -10%. This would mean that ABC Corp has lost more money due to interest expenses than was earned from investments. In this case, ABC Corp would have been better off if it had used the investment funds to pay off debts instead to making an investment.

Net interest margin is a ratio that measures how successful a firm is at investing its funds in comparison to the expenses on the same investments. It typically refers to a bank or investment firm that would invest depositors money, allowing for an interest margin between what is paid to the bank’s client and what is made from the borrower of the funds.

Net Interest Margin Explained

The easiest explanation for this metric is by illustrating how a retail bank earns interest from customer’s deposits. Most banks offer interest on deposits from customers, generally in the range of 1% annual interest. The retail bank at that point, turns around and lends an aggregate of multiple clients’ deposits as a loan to small business clients at an annual interest rate of 5%. The margin between these two amounts is considered the net interest spread. In this case it works out to an even 4% spread between the cost of borrowing the funds from bank customers and the value of interest earned by loaning it out to other clients.

Net interest margin adds another dimension to the net interest spread by basing the ratio over its entire asset base. If the bank has $1 million in deposits with a 1% annual interest to the deposit holders, and it loans out $900,000 at an interest of 5% with earning assets of $1.2 million, the net interest margin is 2.92% (interest returns — interest expenses/average earning assets).

However, if this ratio shows a negative return, the bank or investment firm has not invested their funds efficiently. In a negative net interest margin scenario, the company would have been better served by applying the interest returns against outstanding debt or to fund more profitable revenue streams.

Net Interest Margins in Low Interest Environments

Since the financial crisis of 2008 banks in the United States have been under decreasing net interest margins due to the decreasing Federal Reserve benchmark interest rates. With the Federal interest benchmark rate at 0% for nine years it forced small and large banking institution’s net interest spreads to decrease. This decrease happened while net expenses on the same investments rose for large banks, yet declined for smaller banks.