Finance 101: How Do Banks Make Money?

Have you ever wondered why your checking account is free? Obviously, it’s not because your bank is feeling charitable. Big banks make big money. The kind of money that leads to the obscene Wall Street bonuses we so often hear about. But banks make money even when they’re not involved in Wall Street’s multinational investment deals and billion-dollar hedge funds. Old fashioned “retail banking” (i.e., taking deposits and making loans) is quite a business by itself.

Banks are never short of come-ons for winning new customers; some banks offer new depositors free checks, cash bonuses or iPods (just to name a few).

That’s because banks can’t make money until they have your money.

A Penny Saved Is a Penny Lent

Remember those days when ING Direct and other high yield savings accounts offered interest rates of five percent or more? I used to stash cash into those accounts like crazy and think: “How could banks be handing out money like that?”

It all ties back to the fundamental way banks make money: Banks use depositors’ money to make loans. The amount of interest the banks collect on the loans is greater than the amount of interest they pay to customers with savings accounts—and the difference is the banks’ profit.

For example: You currently have an emergency fund of $10,000 in a high yield savings account that may pay 1.50 percent APY. The bank uses that money to fund someone’s:

• Mortgage at 5.50% APR
• Student loan at 6.65% APR
• Credit card at 16.99% APR

Your bank may have paid you $150 in a year’s time but they earned hundreds or thousands more from the interest on loans (made possible with your money). Now, think about this process repeated with millions of banking customers and billions of dollars.

Fees, Fees, Fees

Yes, banks make a lot of money banks from charging borrowers interest, but the fees banks change are just as lucrative.

• Account fees. Some typical financial products that charge fees are checking accounts, investment accounts, and credit cards. These fees are said to be for “maintenances purposes” even though maintaining these accounts costs banks relatively little.
• ATM fees. There will be times when you can’t find your bank’s ATM and you must settle for another ATM just to get some cash. Well, that’s probably going to cost you $3. Such situations happen all the time and just mean more money for banks.
• Penalty charges. Banks love to slap on a penalty fee for something a customer’s mishaps. It could a credit card payment that you sent in at 5:05PM. It could be a check written for an amount that was one penny over what you had in your checking account. Whatever it may be, expect to pay a late fee or a notorious overdraft fee or between $25 and $40. It sucks for customers, but the banks are having a blast.
• Commissions. Most banks will have investment divisions that often function as full-service brokerages. Of course, their commission fees for making trades are higher than most discount brokers.
• Application fees. Whenever a prospective borrower applies for a loan (especially a home loan) many banks charge a loan origination or application fee. And, they can take the liberty of including this fee amount into the principal of your loan—which means you’ll pay interest on it too! (So if your loan application fee is $100 and your bank rolls it into a 30-year mortgage at five percent APR, you’ll pay $94.40 in interest just on the $100 fee).

Recently, banks are taking a lot of heat for interest rate hikes and fees going out of control. Giving banks business may seem like putting yourself in harm’s way, but of course, it still beats hiding your money under a mattress. Understand how banks work, however, and you’ll know where to lookout for fees and how to avoid lining banks’ pockets by paying more interest than you’re earning.

About the Author: Simon is a recent college grad living in Brooklyn. He writes for an interest rate-tracking Website and maintains his own personal finance blog, the Realm of Prosperity.

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