A net interest margin is a measurement of the difference between the revenue generated by investments and the amount of debt obligations associated with those investments. Businesses assess this type of margin as a means of determining if they are making more money than they are losing. In like manner, a bank would look closely at the difference between the generated interest income and the amount of interest they pay out to depositors in order to determine if the bank if earning more than it is paying out. Typically expressed as a percentage, the net interest margin indicates whether current strategies are working, or if changes should be made to reverse a negative trend.
A simple way to understand how a net interest margin is calculated would be to consider the difference between the interest income earned by a bank on loans to customers and the amount of interest that is paid out to depositors. Assuming the bank had total loans of $100,000 US dollars (USD) during a given day, and earned interest income that amounted to $5,000 USD while paying $3,000 USD in interest, the bank would earn a net interest margin of 2%. In this scenario, the bank experienced a 2% gain on its investment activity in regard to the loans, indicating that writing the loans has in fact generated a return on that investment.
At times, a net interest margin may indicate that a particular investment strategy is not working. For example, if the bank had earned less interest income from the issued loans than the amount of interest paid to depositors, the percentage of the margin would be negative. At that point, the bank would need to reassess how it does business, since the investment in the loans is not providing enough income to offset the amount of interest due to depositors. Unless changes are made within a reasonable period of time, the bank may find it necessary to restrict or eliminate certain bank services, or possibly close altogether.
While the net interest margin is only one of several indicators of the financial stability of a company or a financial institution, the calculation can provide insight into what investments are generating a decent amount of return and which are not performing up to expectations. By using this simple formula to evaluate the current level of return versus the debt, it is easier to identify where to make changes in order to improve the overall financial well-being of the organization.
