How Banks Make Money
Reading time: 3 – 5 minutes
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.
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Yes, I hear that’s why banks are giving out so many coupons where people can “open a bank account and get $150″.
Also, Bank of America is now in a class action lawsuit because of the way it would order certain charges to debit cards which would cause people to incur overdraft fees.
Good topic,
Let’s not forget the biggest money maker of all, interchange fees. For example, when you purchase something on your debit bank card the retailer has to pay the issuing bank a fee, if you pay via debit (electronic transactions) thats when you put in your debit pin number, businesses pay a lesser fee let’s say .10 cents. That’s small compared to when you opt to sign a receipt for credit, this is known as a offline transaction (2%) which goes through VISA or Master Card network. Banks charge more for these types of transactions and some banks may encourage the user to go this route. Either way, every time you purchase something on your card, debit or credit banks make money. One last note, how do you think Russal Simmons makes money from the Russ Card? It’s a pure number games! Peace
@Keish – BofA is trying to survive now so I wouldn’t doubt that they are facing all kinds of suits. Now they are charging people 5 bucks to use your Debit card. It’s funny as in the past they didn’t want you to get money out of the bank they wanted you to use your Debit card everywhere. Well it’s the way of the banks until a better system comes about everyone will put their money in there for no reason.
@HD – Well the people whose business is to hold your money surely knows how to make money. Every business transaction floats through them and they have the system on lock all the way around. I think we should all think about owning our own banks so we can make money off other people’s money.
The Rush card is a endorsement deal so I am sure he makes money off the top.
A few years back, you name the bank and I had some kind of “relationship” with them.
All of a sudden, there were mumblings on business blogs, websites, and podcast about them FREEZING perfect-payment-history folks and businesses lines of credits for absolutely no reason at all. I saw the headwinds coming and knew it was time to make a move.
Fast forward to today and you have what you mentioned FreeMan about the BS debit card fees, the low interest rates on deposits but sky high rates on loans and just plain ole janky sh!t they do now-a-days to earn over-draft fees. Like at Chase if you write Me a check for $50 these koksukerz wanna charge Me $7.50 to cash the dayum thing…smfh. The Monster-Mega-Banks had to do all this janky mess because they ALL got caught up in the mortgage meltdown + derivatives disaster.
Tis is why I moved over to a Credit Union (Lockheed) YEARS ago. No matter what state you’re in there is a local credit union you can join that pays better rates in savings, offers lower rates on loans, has as close to a free checking as you can find anywhere with all the necessities like online banking, billpay….etc.
Anybody still banking with some of the Monster-Mega Banks (unless you holding MAJOR pay-pa) is loco!!!
I am leaning towards going to the internet banking for a lot of my stuff as I don’t usually go to the bank anyway. So Ally (which is General Motors) or E-trade pretty much gives you exactly what the major banks give you. Plus since they don’t have a branch they usually absorb all the charges when you take money out of a ATM. So it’s a win win to me but we’ll see how they adjust to the new laws.
You might be right with the credit unions as they are everywhere and you probably aren’t looking for them. But teachers, aircraft, major companies and just about any union has credit unions. It’s something to think about.
This is what happens when you are a Customer all costs or losses usually get passed on to you and there’s nothing you can really do about it but complain. Most cats don’t want to change banks like they were with us when we were going to get jumped! It’s crazy!
That why when I get my money right I will open up a local bank or credit union. I want in on those profits myself. Im thinking I will need 2 mill to open one. Thats b/c of insurance and I think its a fed law that whatever you have in your bank you need that amount in reserves….I go that from my accounting class but ofcourse I will need to do more research.
One day I will own some of everthing. yolll want be going go buffet and paying 35k for his advice.
yoll will be coming to me and ill be happy to take yoll 35k for a dinner date.
The empire homie is everything that makes money. And, since we aren’t a Sucker saying we love our jobs and got a passion for sewing it allows us to own everything and anything.
Once you understand the chip$ in banking it’s just natural for you to include that somehow in your portfolio for this game. I see it too and I don’t even need it to be that big as I can do a local bank and make some chips. Once you get further into your knowledge of banks you’ll see they are writing off everything from cars, houses, first class flights, G5′s, suits, dinners and a whole lifestyle. Owning a bank in this game is JOB 1.
I’ve been working in banking since I gradauted from college and its definitely the power level of money. Every part of society is touched by the banking system, so if you own it, you own a piece of everything. Including the government at some level. My long term goal is to open my own bank, so I’m trying to soak in as much information as possible about all the levels it reaches.
Banks makes loads and loads of money based off fractional reserve banking. Banks are required to keep a certain amount of money as cash reserves but they can take the rest of that money and invest it elsewhere. So, someone makes $100 deposit. The bank takes $20 for the cash reserve and then uses the other $80 to invest. The same thing happens with depositor and after depositor and the money keeps being chopped up, divided and reinvested. This whole system hinges on the belief that banks runs(people being scared and taking all their money out of the bank) will not occur. But when they do, the banks fall on their face a la Washington Mutual.
Banking basically breaks down to who’s loaning money to who. When you make a deposit into a bank, you’re loaning the bank money to invest. The same way the bank lends you money to start a business. The same way you’re loaning money to the government when you buy bonds. In reality, banks are not doing anyone any favors since they’re in the exact same position as the guy who asks for a loan. The banks just have flashy commercials telling you they’re “on your side.”
I think if more people knew how the banking system worked, the banking system couldn’t pull some of the things they do. But since most people still have no idea how banks make money, they continue to be bamboozled. Some people actually believe their money just sits inside the bank until they withdraw SMH.
What’s funny about the banks is they have oligopoly going same as with the airlines. All this is illegal but when one raises rates all of them seem to move together. Besides that they are the Devil in the Blue dress that disguises herself as weak and innocent but is really there pulling strings with your money. It’s amazing that most cats see them as being some little guy who helped the butcher through a tough winter.
Shit I have a sweeper account on my business account too. So I know exactly what you are talking about when the money is taken to make interest. The banks are a voluntary evil pretty much endorsed by the government and literally charges you for them using your money. It’s a devilish scheme indeed. But, with all that said we don’t complain about the game we get in it. And, anyone who is thinking about a empire should include a small town bank for their portfolio.