How Do Banks Make Money?
Do you ever wonder how your bank can afford its location, overhead and staff? Or, how do banks make money when they give away free checking accounts and pay interest rates on savings? Financial products aside, knowing how the banking system works as a whole will help better inform you of the role your money plays.
Read: How to Guard Your Wealth From a Potential Banking Crisis With Gold
How Do Banks Make Money?
Here’s a look at the ways that banks and credit unions make money, often off your money, no less:
Deposits
Fees
Interchange fees
Investments
1. Banks Make Money Off Deposits
Banks know how to leverage money in genius ways. When you deposit money into your savings account or certificates of deposit, your bank will pay interest as an incentive for you to park your cash there. That’s because banks need your money to make loans. Your cash isn’t really physically in your account, waiting — your bank is making lucrative deals lending it to other customers and businesses until you need it.
Don’t be alarmed as your money will be there when you want to withdraw it. The Federal Reserve insures your money against loss through the Federal Deposit Insurance Corporation for up to “$250,000 per depositor, per insured bank, for each account ownership category.”
So how do banks make money on savings accounts? In a nutshell, by lending out the money in your account and charging more interest than it pays you.
Imagine this: you currently have $20,000 put away in a high-yield savings account at a 1.90% annual percentage yield. You’ll be earning about $384 per year, or $32 per month, in interest. But your bank can lend your $20,000 out at the following rates:
24.74% APR for a credit card
3.83% APR for a home mortgage
2.49% APR for an auto loan
Your bank might pay you $384 over a year but it can make thousands off lending your money. Now imagine that process repeated with every customer with a savings account. That’s a positive net interest margin — an indicator that the bank is profitable because it’s making more money than it spends.
2. Banks Make Money With Bank Fees
Fees are one of the more obvious ways banks make money. Imagine millions of customers paying the following banking fees regularly:
Account fees for having a bank account
Fees from loan applications
Overdraft fees
Monthly maintenance fees
Out-of-network ATM fees for cash withdrawals
Commissions charged for investment services or making trades
Penalty charges like credit card late fees and bank overdraft fees
And then there are credit cards. How do banks make money off of credit cards? Charging interest when consumers don’t pay their card balances in full each month is one way. But credit cards have a whole set of fees, like over-the-limit fees, late-payment charges and annual fees you pay just for having the card.
Banks charge fees to earn money and consumers try to avoid fees to save money. It’s a battle many consumers lose, and the fees add up to a tidy profit for a bank.
3. Banks Make Money With Interchange Fees
Retailers pay interchange fees every time a customer uses a credit or debit card in a sales transaction. Interchange fee rates are set by credit card companies and are normally a percentage of the purchase plus a flat rate.
Here’s a simplified example: The interchange rate set by a credit card provider for each transaction is 2.00% plus $0.15. You buy something for $100 with your debit card. The small business or store would pay an interchange fee of $2.15. The store keeps $97.85 of the purchase price, and the $2.15 interchange fee goes to the bank that provided you with the credit or debit card.
4. Banks Make Money Through Investments
Investment banks are different from commercial banks. They make their money by selling services to companies, governments and investment funds instead of earning their money from consumers. Although this doesn’t apply to consumers, it’s good to know it’s another way banks make money, thereby making it possible for you to enjoy your free checking account.
Investment banks earn fees and commissions from:
Trading shares, currencies or other products
Advising clients on companies they might want to merge with or how they can save on tax through investments
Financing companies through commercial bank loans or by issuing shares or corporate bonds to help fund a company
Researching companies and industries and selling the findings
Final Take
How do banks offer free checking accounts and so many other products and services and still make money? Whether it’s banking services or account balances, there are many ways financial institutions make a profit. So next time you visit your local branch, don’t feel too guilty about taking some extra candy.
FAQ
Here are the answers to some of the most frequently asked questions about how banks make money.
How profitable is owning a bank?
Banks make money in many areas. For example, they may charge small fees for bank accounts, interest rates off loans or credit card interchange fees. In general, banks bring in 10% to 15% of net profits and 7% to 10% return on investment.
What is the largest source of income for banks?
One of the primary sources of income for retail or commercial banks is interest income.
How do banks make money from bank accounts?
A key way banks make money from bank accounts is through fees such as overdraft fees, maintenance fees, service fees and more.
How do banks make money off credit cards?
Banks make money off of credit cards through interchange fees. Retailers pay these fees every time a customer uses a credit or debit card in a sales transaction. Credit card companies set the rates for these fees and they are normally a percentage of the purchase plus a flat rate.
Caitlyn Moorhead contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: How Do Banks Make Money?
