What is Interest Income?
The revenue a lender earns for using their funds is called interest income. It is also regarded a revenue that an investor gets from their investments made over a time period.
Almost all organizations and individuals own financial assets, which earn some kind of an interest. Such interests that they earn from those investments are considered as income. When the expense for paying the liabilities is deducted from the revenues generated from the assets in a bank is known as net interest income. Any bank’s assets usually constitute of different types of securities, mortgages, commercial, and personal loans. On the other hand, the liabilities for any bank are the deposits made by its customers. The extra revenue, which comes from the interests on assets minus the interests paid to the customers on their revenues, is nothing but the net interest income.
Depending on accounting’s accrual method, interest is recorded while it is being earned and not essentially when it is being paid. However, accurate accounting for interest needs a thorough understanding and familiarity with the terms and conditions of the investment. Ideally, the computation of the accrued interest depends on factors such as the investment balance, the compounding period, and the rate of interest.
Diving into Net Interest Income
Some banks demonstrate more sensitivity to their net interest income as compared to others when interest rates change. It can keep changing because of many factors like the assets and liabilities types, which are held and if such liabilities and assets have variable rates or fixed rates. Those banks with variable rate liabilities and assets are more susceptible to changes in the rates of interests as compared to banks where the assets and liabilities have fixed rates of interest.
In fact, the asset types that earn interest for any bank may range from auto loans to mortgages, commercial loans for real estate, and personal loans. It will eventually have an impact on the rate of interest earned by a bank from its assets, as well as the net interest income post deducting the interests that are paid to its depositors. Plus, the same type of loans may have fixed or variable rates. The phenomenon is more common in the case of mortgages as the banks provide adjustable and fixed-rate mortgages. The loan portfolio quality is another factor that affects the net interest income in situations like job losses and a deteriorating economy. These circumstances can lead to borrowers missing their loan payments, as well as reduce the net interest income of a bank.
Net Interest Income instance
In case a bank has a one billion USD loan portfolio and is earning an interest of 5 percent, the interest revenue of this bank will be 50 million USD. On the other hand, when the same bank has customer deposits worth 1.2 billion that earns an interest of 2 percent, the expenses on interest will stand at 24 million USD. Deducting 24 million USD as interest expense from it interest revenue of 50 million USD, the net interest income of the bank will be 26 million USD.
Banks can actually have the ability to earn higher interests from their assets as compared to making payouts towards their liabilities. However, that does not indicate such banks are profitable. Similar to other businesses, banks also have extra expenses like employee wages, management salaries, utilities, and rent. Such expenses need to be further deducted from the bank’s net interest income and then the profitability may be negative. Yet, banks can have extra revenue sources apart from getting interests on loans sanctioned like investment advisory or from investment banking services. It is imperative for the investors to contemplate about ancillary expenses and revenue source apart from the net interest income while evaluating banks.