Interest spread

An interest spread is a premium that is charged on a benchmark index to calculate the interest rate that is applied to a financial asset / liability. For example, Libor + 1% or Euribor + 1%.

Interest spread

When certain products or financial assets are bought or sold, they are associated with an interest rate. This interest rate will be your explicit return. It will be received by the person who buys it (when it is an asset) or it will be paid for it (when it is a liability). A certain percentage is added to this interest rate, which will be conditioned by various circumstances.

The difference between a higher or lower spread is determined by the liquidity, maturity, installment risks or the credit risk associated with the customer, among other circumstances. The greater the risk associated with the product or the greater the risk of default, the greater the interest differential.

Therefore, an interest differential, understood in a simple way, is the difference between the interest rate of the reference index and the interest rate at which the product in question is quoted.

It is also known as the interest differential to the difference between the interest that a bank charges for offering long-term loans and the interest it offers for keeping its clients’ money (usually through deposits). This differential is the benefit that banks obtain by assuming the risk of lending at terms greater than those they lend. This is because the deposits it offers are usually short-term, while the loans it grants are usually very long-term (mortgages, personal loans, etc.).

Most common interest spreads

In financial markets there are an infinity of interest differentials. The most typical ones are discussed below.

  • Differential of interest of a mortgage: It is the differential that the bank charges the client when he contracts a mortgage loan. The bank uses a certain reference depending on the country in which it is. For example, in Europe the 10-year Euribor is used to calculate the mortgage.
  • Interest differential of a corporate bond: It is the differential that applies to a corporate debt issue of any company. For this, a risk-free asset is usually used as a reference. This risk-free asset is usually the 10-year sovereign debt of the issuing country.
  • Interest differential between currencies: It is the interest differential between a currency pair. For example, if the Canadian dollar has an interest rate of 2.25% and the Mexican peso has an interest of 7.5%, we would have a differential of 5.25%.

Example of interest spread

Mr. Petersplatz is a resident of Germany and goes to the bank to request a mortgage loan. He needs € 200,000 to buy a house. Suppose that the 10-year Euribor (the main benchmark for calculating mortgages) is at 2%. When studying his personal situation and analyzing the risk of the operation, the bank that Mr. Petersplatz goes to, decides to apply an interest rate for the mortgage loan of 3.5%.

The 3.5% interest applied has two components. 2% (cost of money for the bank) and 1.5% (interest differential). Therefore this interest differential would be what the bank would earn for the amount loaned to Mr. Petersplatz.