What Is an Interest Rate Spread?

Jim B.
Jim B.
Man with hands on his hips
Man with hands on his hips

An interest rate spread is a measurement used in a variety of different applications which calculates the difference between two separate interest rates. The spread is often calculated by studying a specific rate being offered to some standard rate which is known as a benchmark. If the interest rate spread is significant, the higher rates will offer the receiver of the interest higher payments, albeit with greater risk attached. In terms of a company, the interest spread can refer to the difference between what it is paying out on all of its different debt obligations and what it is receiving from the loans it has offered to others.

Interest rates are an important component of the business world, as they signify the reward that one party gets for lending money to another party. Loans permeate a multitude of business transactions. People using credit cards, taking out a mortgage loan to buy a house, or investing in bonds need to be concerned with the interest rates tied to these enterprises. As a result, the interest rate spread can make a great difference in the fortunes of many individuals and institutions.

Although it can be used in a number of circumstances, the most common way for an interest rate spread to be applied is when a particular rate is compared with some standard rate. The standard rate is known as the benchmark, and all other rates available in a particular market are set against it. For example, United States Treasury bonds are often used as the benchmark in the bond market, since they are low-risk and the rates that are quoted on the bonds can almost assuredly be delivered.

Anytime that an interest rate spread is excessive, it usually signifies that significant risk is involved. Some lenders will offer unsecured loans to customers with questionable credit at extremely high interest rates to compensate for the risk that the loans will not be repaid. In the same manner, corporations with low credit ratings may issue bonds at a high interest rate to investors, raising the interest spread but also raising the level of risk for the investors. The high spreads in both cases are accompanied by excessive risk.

Another use of the interest rate spread is as a measurement of financial strength for a particular company. A company's net rate spread is the difference between the amount of interest it pays out to its lenders and the amount of interest it takes in from borrowers. If the rate is consistently positive, the company is probably on strong financial footing. On the other hand, spreads that are trending downward can indicate that a company is heading for debt.

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