Introduction
Everyone reading this article will have a savings account or checking account with a local high street bank; most of these are free, so how do banks make money exactly?
We all use bank accounts every day of our lives, but only some of us know precisely “how do banks make money“.
We have all heard the stories of bankers making millions and spending lavishly, but how do they afford to do this when the bank accounts we are opening with them are free at the point of use?
Surely they can’t all be making that much money, can they?
The quick answer to this question is, yes, banks make a lot of money.
They make their money in various ways, the main ways being interest on loans, fees charged for services, investments, and other banking fees.
Bank Deposits.
When you deposit your money into the bank, what do you think happens to that money?
Do you think it is sitting safely in a vault collecting dust, waiting for you to come and draw it out one day when you need it?
Well, the answer to this is no, it’s not; as soon as the banks have your bank deposits, they turn around and lend it to someone else as credit card debt, a loan, a mortgage, or other financial instruments where they can make money from using your money which you deposit into your account.
The bank will lend your money out, in the case of credit card debt, at an APR of 30%+ while paying you 1 or 2% interest on the money that they have lent out.
Banks can take advantage of what is referred to as the “time value of money,” where banks will charge a higher rate for a loan than they pay for a deposit. This rate difference is referred to as the Net Interest Margin (NIM), which is how banks make their money.
A bank run.
Have you heard of the phrase “a run on a bank”? This is where many customers demand the withdrawal of their money from a single bank simultaneously.
Even though everybody’s bank balance will show what they have in their account, the bank wouldn’t have the liquidity to pay everyone’s money back to them at the same time; this is because they have lent it out and invested it to make themselves more money.
So, how do banks make money on individual products?
Banks have various methods of extracting money from their clients with multiple types of fees. Below are some of these bank charges explained in a bit more detail.
Personal loans.
By far, the most significant way banks earn money is through the charging of interest on loans and generating interest income, when you take out a loan from a bank, whether an auto loan, a mortgage, a personal loan, or a business loan, you will pay interest on top of the original loan amount.
The amount of interest charged will depend on several crucial factors when you take it out, including the type of loan, the length of the loan, and your credit score, but it typically ranges from around 3% to 10%.
When you are borrowing money, you must read all of the terms and conditions that the banks offer, and make sure you read the small print so that you aren’t hit with any unforeseen monthly maintenance fees.
Investment Banking
Another way how banks make money is through what is known as investment banking. Investment banks help companies raise money by issuing and selling securities. They also help companies buy other companies.
When a company wants to make an initial public offering (IPO), they usually hire an investment bank to underwrite the IPO.
Commercial Banking
Commercial banks provide bank accounts and financial services for businesses. Their services include business loans, credit cards, and lines of credit. They also offer merchant services, which allow companies to accept credit card payments and charge a transaction fee on every sale.
The fees for these services vary depending on the type of service and the banks. For example, a business that wants to open a line of credit will usually pay a higher fee than a business that wants a basic checking account.
Overdraft Fees
If you do not maintain a minimum balance above zero, The banks charge an overdraft fee when a customer spends more money than they have in their account.
The banks will also charge interest on the amount of money that has been overdrawn.
A study conducted in 2017 showed that banks charged an average of $35 for an overdraft fee. Once people get into a spiral of overdraft fees, it’s challenging to get out of it, as you keep needing to borrow money to pay the fees again and again if you find yourself in financial difficulty.
Overdraft fees can range from $25 to $38 every time you go over your overdraft amount, depending on the bank.
Many banks will allow you to link your checking account to a savings account or credit card so that if you do overdraw your checking account, the money will be automatically transferred to the overdrawn account, so you don’t get charged, so look out for this feature with new checking accounts.
Annual Fees
Some banks will also charge an annual or monthly service fee for some of their accounts and services. This is usually a percentage of the total amount deposited into the account or a flat rate fee.
Annual, or monthly account fees can also be changed if you don’t maintain a minimum account balance, so make sure you know what that is before opening an account.
Transaction Fees
Another way banks make money is through transaction fees. Whenever you use your debit/credit card to make a purchase, the bank will charge the merchant a small fee for processing the transaction. The banks will also charge you a fee if you make a withdrawal from an ATM that is not affiliated with your bank.
Foreign Transaction Fees
If you use your debit or credit card abroad, the banks will also charge you a foreign transaction fee. This is typically around 3% of the total amount spent.
Suppose you use your regular debit or credit card abroad to withdraw cash. Banks will also charge excessive withdrawal fees if you try to withdraw cash from an ATM abroad.
As a regular traveler, I have just discovered the Revolut card, which I just obtained for a trip to Portugal recently., and I am impressed with it.
You preload the card with your local currency, then use the contactless card, and the forex trades are made as you spend with no hidden fees.
This means you save all foreign transaction fees from your traditional bank. The bank card partners with an app on your phone, making it really easy to use and really easy to check your balance. Check them out here to save money if you are spending abroad.
Late fees
The banks will also charge late payment fees if you miss a credit card or loan payment. The banks will also report any late payments to credit agencies, which will damage your credit score.
So try to make all payments on credit cards or loans on time every month.
What to consider when you are choosing a new bank.
Not all banks are equal; some online and local banks that offer personal finance products provide some excellent services; you can use a small personal bank rather than some big players and get better interest rates on savings accounts, for example, or get lower wire transfer fees.
Credit Unions
Operative banks or credit unions are a great way to get started in banking. They offer many of the same services as the big banks but are usually substantially cheaper.
There are some things you will need to consider before you choose a credit union, such as:
- The fees they charge
- The interest rates they offer
- The type of products and services they offer
- Their customer service record
- Whether or not they have branches near you.
You should also read the terms and conditions of any account you’re considering opening to ensure you understand all the fees and charges that may apply.
Other helpful information.
If you are unhappy for any reason with the way you are being treated or charged by your banking institutions, commercial bank, or other financial institutions.
In that case, you can complain to the Consumer Finance Protection Bureau if you are based in the USA; if you are in the United Kingdom, you can make a complaint to the Financial Ombudsman Service.
Final thoughts.
As you can see, banks and financial institutions make money in various ways. The main focus of any bank is to make money.
The main ways are through interest on loans, fees charged for services, and investments. By understanding how banks make their money, you can be a more intelligent consumer and avoid some fees that banks charge.
When choosing a financial institution, you need to understand your needs and how bank fees and interest expenses will impact your money.
Before you consider moving to a new banking institution, be mindful of how you will use your bank account, what the banking costs are, what ATM fees are, minimum balance fees, etc., as these are all the ways traditional banks can take money from you.
Now you are armed with all the detail you need so that the banks can’t take as much money from you as they would have without this knowledge.
