Banks have been around as long as anyone can remember, dating back as early as 2000 BC. They perform essential services, including providing a safe place for individuals and companies to keep their money. They process endless transactions and pay the people we want to pay, they even give us interest on some of our money that they hold. So how do they make money to be able to stay in business?
While it is true that the purpose banks serve is to help manage our money for us, they don’t provide those services for altruistic purposes. They’re businesses designed to make a profit, just like any other business. So how can they afford the overhead of having a branch on nearly every corner, not to mention the other costs associated with running a successful business these days? As it turns out, banks use the money deposited by their customers to make money, both directly and indirectly.
Loans: making money by letting others borrow your cash
The money that you deposit in a savings or checking account doesn’t just sit there collecting dust. Banks tap into their deposits to make loans to individuals and commercial ventures. If you obtain a loan from your bank, in a very real way, you’re borrowing your own money.
Banks make money on loans by charging interest. Whether it’s a mortgage, a car loan or a personal loan, they all have interest rates that go along with them. Interest rates are lower for customers with solid financial profiles and good credit. That’s because such customers represent a lower risk of default. Such customers are also more desirable, and have their pick of banks and other lending institutions, so interest rates must be kept low to attract them.
By contrast, borrowers with only fair credit or less solid financial backing are frequently charged higher interest rates because they are more likely to default and therefore less desirable. In some instances, banks may require a co-signer or collateral before approving a loan. Such borrowers accept higher interest rates because they have few opportunities to borrow – and are often happy to be approved at all.
Credit cards: annual fees, membership charges, and more
While the logo of your favorite department store or online shopping locale may be on the front of your credit card, chances are that if you flip that card over you will see the words “Issued by the Bank of…” Most credit cards and charge cards are issued by banks. Banks frequently offer credit cards to their customers as an incentive to persuade them to remain as customers of the bank.
The interest rates charged by banks for their credit cards represent another important source of income. This is in addition to any monthly or yearly maintenance or membership fees, over the limit fees, missed payment charges, etc. Those all add up to big money for these card issuers as well.
Fees, fees, and more fees
Banks “earn” a great deal of their income from charging and collecting fees from their customers. There are fees for just about everything these days – transaction fees, withdrawal fees, overdraft charges, and the list goes on and on. There are even some banks who charge a “teller fee”. This means that you have to pay a fee to talk to a live person when you have a question about your account. Many people find it ridiculous to trust an institution with your hard earned cash and then have to pay a fee to ask them a question about it, but many banks are beginning to charge these costs to their customers in an effort to encourage more on-line or automated inquiries, thus allowing them to cut down on the number of live employees they have to have.
While some checking accounts carry monthly fees, many banks offer free checking as a means to draw new customers. But banks that provide free checking manage to collect money from other fees. You may dislike banking fees, but by shopping, avoiding overdrafts and using a bank’s own ATMs, you can avoid most of them.
- ATM Fees. Many banks allow free withdrawals from their own ATMs, but charge hefty fees for withdrawing from “out of network” ATMs.
- Overdraft Fees. Overdraft fees of $30 to $35 are not uncommon, and some banks at least appear to make withdrawals that allow them to collect the maximum number of overdrafts possible.
- Application Fees. Banks and lending institutions often charge application fees for applying for a loan. In some cases, the fee is added to your loan principle, which means that you end up paying interest on the application fee too.
- Commissions. If your bank offers investment services along with regular banking operations, chances are it charges fees. Those fees are often much higher than the fees charged by discount investment brokers.
Investments and securities
Banks also make money from investment speculation. Mortgage-backed securities are just what they sound like – investment instruments sold to speculators backed by mortgages held by banks. Smaller banks sell bundles of mortgage-backed securities to larger banks and financial institutions which may buy hundreds or even thousands of such mortgage backed securities.
Those financial institutions make their money by selling tranches—slices from those bundled, mortgage-backed securities. In this process, individual houses cease to exist, at least financially. The process of selling tranches is lucrative during a booming housing market – but disastrous during an economic downturn.
Your money is safe
You may feel anxiety about risky investments and loans made by banks, but you need not worry. Checking and savings accounts up to $250,000 in banks are protected by the Federal Deposit Insurance Corporation (FDIC). Deposits in credit unions up to $250,000 are protected by the National Credit Union Administration (NCUA).
While banks do perform essential services for their customers, it is because they too benefit from the relationship. Perhaps one of the most interesting business models you will find, banking relies on the income and earnings of others to be able to keep their operation going. After all, a bank is only a bank if it has other people’s money to work with.