Net Interest Income (NII) – What is It and How is It Calculated?
What is Net Interest Income?
Net Interest Income (NII) is the difference between the interest income earned on loans, investments, and other interest-earning assets, and the interest paid on deposits and other interest-bearing liabilities, such as borrowings. It is a measure of a financial institution’s profitability from its core business of lending and borrowing money.
How Does Net Interest Income Work?
Net Interest Income (NII) works by measuring the difference between the interest income earned by a financial institution on its interest-earning assets and the interest expense paid on its interest-bearing liabilities.
When a bank or other financial institution lends money, it charges interest on the loan, and this interest income is a source of revenue for the bank. At the same time, the bank needs to pay interest to depositors who have deposited their funds with the bank, and this interest expense represents a cost for the bank.
Let’s understand this with an example.
Example
For the financial year 2022-23, XYZ Bank has obtained a loan portfolio of Rs.15 crore at an average 5% interest rate. The interest revenue, therefore, stands at Rs.75 lakh. Furthermore, with outstanding customer deposits of Rs.10 crore at 2% interest, the interest expense turns out to be Rs.20 lakh. XYZ Bank will thus generate Rs.55 lakhs as the NII for 2022-23.
Importance of Net Interest Income (NII)
Here are some of the importance of net importance income:
- Serves as an important metric for financial institution’s profitability and financial health.
- Banks rely heavily on net interest income to fund their operations and make profits.
- Serves as an indicator of the interest rate risk faced by a financial institution
How to Calculate Interest Revenue, Net Interest Income, Net Interest Margin and Interest Expense
1. Net Interest Income Formula
As mentioned above Net Interest Income is calculated as:
- Net Interest Income = Interest Received – Interest Paid
2. Net Interest Margin Formula
Net Interest Margin measures the difference between the interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities. The formula is:
- Net Interest Margin = [Interest Revenue – Interest Expense] / Average Earning Assets
3. Interest Revenue Formula
Interest revenue is calculated as:
- Interest Revenue = Effective Interest Rate * Financial Asset (valued at its gross carrying amount)
4. Interest Expense Formula
Interest expense refers to the cost of borrowing funds from a lender, usually in the form of a loan or a line of credit. It is the amount of interest that a borrower pays to the lender for the use of the borrowed funds. It is calculated as:
- Interest Expense = Effective Interest Rate * Financial Liability
Net Interest Income vs Net Interest Margin
Follow the table below to understand the difference between Net Interest Income and Net Interest Margin
| Parameter | Net Interest Income | Net Interest Margin |
| Definition | Net interest income is the difference between the interest earned on loans, investments, and other interest-earning assets, and the interest paid on deposits and other interest-bearing liabilities. | Net Interest Margin is the percentage of difference between the interest earned on interest-earning assets and the interest paid on interest-bearing liabilities, divided by the average interest-earning assets. |
| Formula | Net Interest Income = Interest Received – Interest Paid | Net Interest Margin = [Interest Revenue – Interest Expense] / Average Earning Assets |
Assets that Generate Interest Income for Investors
Types of assets that help investors earn interest income are:
1. Corporate Bonds
Investors can earn interest income on corporate bonds when they reinvest the interest earned annually. Accumulation of additional interest income occurs when investors compound their principal with the interest earned for another year.
2. Indexed Securities
Various indexed securities provide interest rates at a particular discount of the market rate. The balance to be paid is adjusted for inflation at the time of maturity. If the adjustment during the maturity is positive, it will be added to interest income.
3. Treasury Bills
Interest is determined by the difference between purchase price and sale price. Investors can earn additional income if the interest rate in an economy drops and treasury bills are sold,
Assets that Generate Interest Income for Bank
Below mentioned are the types of assets that could help generate interest for bank:
1. Loans
Banks offer loans to individuals and businesses with interest. The interest component helps generate income for the bank.
2. Securities
Banks can invest in various types of securities, such as government bonds, corporate bonds, and other debt instruments. These investments generate interest income for the bank.
3. Deposits with Other Banks
Banks can also earn interest income by depositing funds with other banks or financial institutions.
4. Cash and Cash Equivalents
Banks can also earn interest income on their cash and cash equivalents, such as funds held in reserve accounts with central banks.
5. Other Interest-earning Assets
Banks may also have other interest-earning assets such as credit card receivables, leases, and other loans or investments that generate interest income.
Final Word
Statistically, there has been a gradual decline in the net interest income earned by banks and other financial institutions. One factor responsible for that is the declining interest rate margins. Rather, banks instead aim to generate more revenue through trading and various financial operations.
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FAQs
Non-performing assets, also popularly known as NPAs are loans, credits or any advances that have not been paid back to the financial institution. In case of an extended period of non-payment of loans, the lender is going to force the borrower to sell a valuable asset that was part of their debt agreement.
Net interest margins are the differences between interest income generated and the income paid adjusted for their total assets. Higher the margin, the better the bank’s financial performance and thus more profitable to invest in its stock.
There are various factors that can affect net interest margin. One of the most significant factors is supply and demand. The increase in loan availing and monetary policies set by central banks also play a vital role in affecting the net interest margin.
Interest incomes are essentially earned on financial assets. When assets turn into NPAs, it halts their income generating capacity and thus the overall interest income falls.
Net interest income is the difference between interest earned on assets and interest paid via deposits to customers. Net interest margin is an adjusted measure representing the percentage of interest income on total assets.
NII or net interest income is a financial performance metric that measures the difference between the interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities. It is an important measure of a financial institution’s profitability and financial health. NIM or net interest margin is a financial performance metric that measures the difference between the interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities, expressed as a percentage of the average interest-earning assets.
A higher net interest margin indicates that the financial institution is earning more income from its interest-earning assets relative to the cost of its interest-bearing liabilities. This can indicate a stronger financial position and greater profitability.
Here are some key considerations when analysing NIM:
– Compare with Industry Benchmarks
– Analyse Trends Over Time
– Consider the Composition of Interest-earning Assets and Liabilities
– Evaluate Interest Rate Risk
– Consider other Factors that may Impact NIM
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
