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How Do Banks Make Money?

Banks are in the business of money. Some companies sell goods and others sell services, but banks are in the money business. From credit cards to personal loans to mortgages, banks make money the old fashioned way — they earn it (in interest charges). Well, that and they like to charge random exorbitant fees to their customers, too. But in the end, they are just trying to cover the spread between the money they take in and pay interest on and the money they lend out and charge interest on. It’s a pretty simple concept, if in theory only.

Ever wondered why a bank charges you a 20% interest rate on your credit card but pays you just 1% interest on your savings account? That’s how they make money. That 19% difference, while not all profit, is the spread and how the bank keeps money around to lend out to other customers or companies. Accounts with longer terms like CD’s often pay more than checking accounts because the money you have deposited doesn’t have to be available for withdrawal immediately — they loan it out to other people. Checking accounts pay a miniscule amount of interest because you can walk in any day of the week and take all your money out. Banks must keep enough cash on hand to satisfy the deposits of their customer’s “demand” accounts like these.

In addition, banks are free to lend out their money as long as they stay below the threshold “reserve rate” set by the Federal Reserve. They have to have some money available in reserve, but banks don’t have all of our money sitting around waiting for us to need it. In fact, a lot (most?) money isn’t even real – it’s all on paper. Our system is completely dependent on all of us not asking for money at once, causing a run on the banks. If that happened, chances are you would show up for your money and the bank would say “too bad, so sorry” and not have anything to give to you. As someone (like most of you, I imagine) who as a kid used to think that the bank kept my money in a “David” drawer, the idea that banks don’t actually have all that money on hand kind of blew my mind back in the day.

Banks can also make a healthy income by charging their customers fees for assorted “services”. Checking account maintenance fees, ATM access, overdraft protection plans (for info on the new laws, check out this post), card replacement fees, late fees, service charges, or anything else they can possibly dream up; they are always looking for new ways to make money off their customers, especially right now when interest rates are so low. Even the Greek philosopher Aristotle wasn’t a fan of banks making money off of the money itself:

“The trade of the petty usurer is hated with most reason: it makes a profit from currency itself, instead of making it from the process which currency was meant to serve. Their common characteristic is obviously their sordid avarice.”

At the the end of the day, banks make money by lending your money to someone else, paying you a little bit of their earnings and keeping the rest. In a nutshell, they charge borrowers more in interest charges than they pay you for the use of your money, and that’s how they pay their bills.

(photo credit: Aranami)


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Comments (3)

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  1. Michael says:

    Thanks for sharing. I’m sure many people are asking about this topic and finally enlightened on how this works.

  2. Dawn says:

    The banks also charge fees on pretty much everything to business customers – I get a four page statement detailing all my bank fees each month. They range from “oh, that makes sense” (fees for returned deposited items, for example) to “that’s freaking insane” (cash deposit fees, for example).

  3. Shelly says:

    Dawn,

    While it may seem that cash deposit fees are “insane”, it may help for you to know that banks have to buy and sell cash from the Federal Reserve Bank. They have to pay fees (armored car service, for example) to ship this money. The FDIC requires banks to set and maintain cash limits for each branch that cannot be exceeded. They ship money to the fed at least weekly, and sometimes more often. This reduces the risk to the bank (and to the FDIC) in the case of robbery, or other disasters. Banks also have to purchase (and pay fees for) rolled coin and other items that customers need.

    I really don’t think people understand how regulated banking is these days. Banks are watched closely and squeezed from every angle. The regulations in the last few years have had a huge impact on how banks can make money. It has become much harder. The increased FDIC premiums (due to failed banks and higher risk of failure) have also had a huge impact.

    The bottom line is that banks provide products and services that people need. They are for-profit business. They have to make money to survive. They have shareholders that want a return on their investment or they will get out. Consumers don’t go into other business and expect to use the products, services, and facilites for free, yet they somehow expect it from banks.

    The ignorance about this amazes me.

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