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How Do Banks Make Money With Your Money?

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How Do Banks Make Money With Your Money?

How Do Banks Make Money With Your Money?

Television and radio are full of advertisements from banks offering gifts, free accounts and even cash when you open a new checking or savings account.

This isn’t because banks or exceedingly generous and, although they may appreciate their customers, that isn’t the main reason they offer incentives to get you to open a new account with them.

The fact is that banks don’t make money until they have money.

Fractional Reserve

One of the main ways that banks earn profits is through lending and, because depositors rarely remove the entire amount in their accounts at once, the bank is allowed to lend out most of the money they have collected in the form of deposits.

The Federal Reserve stipulates the minimum reserve ratio, the amount a bank keeps on hand that is not loaned out. This is known as fractional reserve banking. Although banks are permitted to hold reserves in excess of what the federal government requires, but because the bank makes money on what is loaned out, few have what is known as excess reserves.

Interest Rates

One of the ways that banks earn money is by setting interest rates on money loaned significantly higher than what they pay in interest. For example, a savings account may pay only 1.5 percent while credit card interest may be 9.9 percent, loans for cars may be 10.5 percent and mortgages may have rates ranging from 3.25 to 6.5 percent. By charging higher rates on money lent out to customers than what is paid to them for holding their money, banks are able to earn a significant amount of money.

Bank Fees

Beyond interest earned on mortgages and loans, banks also earn money with the fees they charge. Banks make a significant amount of their profit in fees charged, both to customers and non-customers. In overdraft fees alone, banks earned as much as $32 billion in 2012. Other banks charge a fee to cash a check drawn on their bank if the person cashing the check is not a customer and the software used in banks allows them to calculate and keep track of this money and profit. Some of the fees customers face from their bank include:

  • 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).

As banks become more heavily regulated and limited on interest rates or other factors that historically have earned them money, the more many will institute fees in order to make up the losses that may occur.

When choosing a bank, whether for a checking account, savings account or loan, it is important to understand how banks make money. This understanding can help you avoid increasing the bank’s profit at your expense. Fill out our contact form to learn more about the banking system and how banks increase profits.