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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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Comments

  1. That was a really well-done explanation of how banks make money, since I think that a lot of people don’t understand the whole process. As much as interest rates are awful right now, consumers still need to put their money SOMEWHERE, as it’s not feasible not to save. Do you have any opinions on high-yield savings accounts v. CDs v. investing?

    In the interest of full disclosure, I am a writer at a personal finance website, and we recently published an article on CDs, and understanding their terms. What I think is key is that we give a nod to when a CD just doesn’t cut it, and it’s time to start actually investing in the markets. What are your thoughts?

    • Here is th deal on CD’s: Using them as Investing vehicles or income generating tools at this point in time is not worthwhile. Cd’s certainly have some benefits in ensuring your money is safe and the risk is near zero, but thos paltry benefits significantly outweigh the negatives dependant on your age.

      The core reason I am so bearish on CD’s is the fact that they have a negative real reate of return. After taxes and inflation they yield below zero. Lets assume inflation is 2% and you early 1% on a CD ( which is unlikely right now, since banks can borrow money at .25%, and would therefore have an expense in paying you above .25%), forgetting about taxes you lost 1% of the value of your dollar. Thats not to say the money is gone, it is simply worth less.

      Investing is in my opinion the best way to beat inflation. Obviously there are some inherent risks in investing (especially right now) but it sure beats knowing you are losing money.

      CD’s are ideal for the retiree who can’t afford to take on risk, but you may as well stuff the mattress.

  2. Gahh, the link I tried to embed didn’t work! Apologies! Here it is: http://blog.learnvest.com/learnvest-daily/the-cd-a-users-guide/

  3. Consumer gets charged an interest of 22%+ on their credit cards nowadays for their balance. Not only that, most consumers don’t have the money these days to even pay down the principal portion of the credit cards but only the interest portions. Now banks are really dealing in the money. And what do they offer in return on savings & checking account? The percentage is not appealing for sure.

    • Most people that are paying 20 plus percent on their credit cards have made poor decisions leading to these rates and the inability to pay core debts down. Many times correctint this is simply making a decision to sacrafice extras. For example how many people in debt over their heads continue to pay $200 plus per month for cable, $150 a month or more for unlimited data plans, extravagent cell phones, car payments over $300 that are more than rent or the mortgage. There are many more examples but most people aren’t willing to make cuts. Most of the time income is sufficient, but people refuse to adhere to financial plans and core budgets. If anyone out there needs help budgeting, cost cutting etc call me. A thrifty plan can pay down debts and start long term savings for retirement, education or a new home.

  4. Actually, a penny saved is like 10 pennies lent. To truly understand our financial system, you need to understand fractional reserves. It’s the backbone of our system and in my opinion, the biggest problem with our system. For the best explanation I’ve found of fractional reserve banking in easy to understand language, read “End the Fed” by Ron Paul.

  5. Banks are getting desperate these days; bankers have even been known to practically beg customers to deposit money! If you’re wanting to get a loan or line of credit, don’t be surprised if the bank first asks you to make a hefty deposit (in addition to down payment) into a checking/savings account!

    • In general that is accurate information. What you may find these days is the dollars you have locked in to a CD may be costing the bank big bucks. Les say you fixed a rate at 3.75% several years ago on a 10 year CD. The bank realizes an expense near 3.25% on those deposits since the discount rate is at .25%. The bank needs deposits to maintain liquidity, and be within reserve reqirements, but they’d rather pay you .01, or .05. That being said loans and fees are the primary profit generation of banks. As long as they can still collect debit and credit card fees that will be their focus with rates so low. If debit card fees are legislatively eliminated fee generation for banks will get very interesting.

  6. the loans may be the muscle of bank income, but the juicy delicious fat is those penalties…

    anyone care recently overdrawn their account? maybe it was on Wednesday and you had to wait till payday to remedy it? calculate that interest for your “impromptu loan” that was quite likely only in the double-digits… much higher than 5…10…15% overall interest for hefty loans? I recently had the mishap of overdrawing by $23 and when I caught things up the profit margin for loaning me that 23 bucks was almost 1000% profit for the bank…similar stories lead to profit margins for similar accidents around 500% and (at least this is logical) triple digit accidents breaking the 1000% mark easily… so pay with quarters next time you buy a snickers bar, that little chocolate craving might cost you more than 100 bucks…

    • Well written and accurate, but Regulation E to the rescue. Consumers who opt out cannot legally be charged for overdraft fees in using their debit cards. They can still be charged for overdrafting with checks and ACH transactions. Consumers are now protected from exhorbant banks fees.

      Those fees aren’t charged as pure profit. They cover the cost of cover the account, and also the charged off accounts that can be as high as $2000 or more. Unfortunatley many of those fees are charged to cover other customers negative accounts that are all pooled together

  7. All Cash Lifestyle says:

    My Saving bank practices somthing perplexing , even though I have plenaty of $$ in checking about $1,943.00 they randomly throw in a Credit $35.00 into my checking that goes into an overdaft as a loan at 14% , this has been happening quite of then its very underhanded.
    I don’t understand why they practice this pattern —???
    they never giveme a straight answer it’s always well it’s going back to some retroactive timeline — not clear.

  8. HA! If only banking were so innocent… When banks “make money”, they literally “make money”. It’s not entirely accurate that banks are merely loaning out my savings to someone else at a higher rate. In reality, commercial banks literally create money when they make loans. In fact, about 90% of this nation’s money supply is created by the commercial banks, not the FED, as is popularly believed (the FED merely creates the base “reserves”, which is a meaningless term becaues the so-called “reserves” are just more paper. You can’t have paper reserves to back up paper, that’s just nonsense…) Anyway, your nice, friendly neighborhood bank actually creates money out of thin air when you sign on the dotted line for a loan. It is commonly said that we have a debt-based money system in this country, well, that is why. Money is literally created out of debt. In other words, the money for a loan springs into existence at the moment I borrow it, and vanishes out of existence the moment I pay it off. Read the Creature from Jeckyl Island for a thorough explanation.

    BTW, to get a higher rate of return on your saving, Private Real Estate Lending is the way to go. You can earn at least 7% on your money that way, and it’s perfectly safe if you do it right. I have some info on my website about it…

  9. Banks make money because they loan out at least 10 times more money than what they have. They therefore actually create money out of nothing, thin air! This is how 97% of money (in the UK) gets into circulation. Thus, everytime the bank makes a loan, the value of all the money in circulation is devalued by inflation as a result of the addtional input of money into circulation via the loan made.