While the banking system can seem complicated, knowing how banks make a profit can help you understand what happens when you give them your money.
How Do Banks Make a Profit?
Here are the main ways banks generate money:
1. Interest-Based: The “spread”
Banks are very good at putting money to work. To a bank, money is an asset that can be used to make even more money. This is where the spread comes in handy. Essentially, it is the difference between what the bank makes and what it pays out.
When you make deposits in a bank account, such as in a CD or savings account, you might earn interest as APY. This is the percentage of your total deposits that the bank will pay you for keeping your money in the account.
The money you deposit does not sit idly in a box somewhere, however, instead, the bank invests it to earn an even higher return than the APY it pays you.
The difference is called the spread, and it represents one of the most significant sources of income for the bank. Let’s look at some examples of how this might work.
While many people open bank accounts to save money, others borrow money from the bank to fund big purchases such as a home or a new car.
The bank does not loan the money for free – it charges the borrower an interest rate. The amount of interest is usually based on the capital required (the sum borrowed) and a few other things.
In 2019, the average mortgage interest rate stood at 4.75%. On the other hand, the average APY rate on savings accounts stood at 0.05%. This means that the bank is making 4.70% on the money it loans; once you remove the 0.05% APY rate, it pays customers for supplying the money.
Some banks do offer higher APY rates in some cases, reaching 1.0% or more. Choosing a bank account with a higher APY rate can help you grow your account even faster.
Bank accounts such as CDs also offer interest rates higher than average, but can only be withdrawn once the maturity date is reached.
The bank can also invest the money in other ways that may render an even higher return on their investments. These different investments can have a significantly higher risk, but the reward is also much more significant.
If you’re worried about the safety of your deposits, you don’t need to be. Banks have to follow the rules and can’t invest without really calculating their moves. This means that your money is still relatively safe. This is especially true for accounts that are FDIC-insured.
FDIC is short for Federal Deposit Insurance Corporation. While it forms part of the federal government, it is still an independent agency.
The FDIC insures depositors, usually up to $250,000, but you should confirm this with your bank before depositing your money.
4. Bank Fees
Banks also charge several types of banking fees that can supplement their income from lending out money. There are a few different fees, depending on the services being used. We will now look at some of the fees banks charge to make money.
Many banks charge monthly account fees on their accounts. The monthly fees tend to vary according to the type of account, with high-tier accounts tending to have higher fees than lower-tier accounts.
You get to enjoy many benefits for the fees paid – these tend to differ from one bank to the next.
Even so, there are ways to avoid these fees. In some cases, maintaining a minimum account balance or setting up frequent direct deposits will eliminate the fees. There are many types of free checking accounts and free business checking accounts available when you meet the basic requirements.
Certain bank services, such as credit cards, may also carry regular fees. In particular, credit cards usually have a yearly fee, along with other fees that we will discuss in the next section.
These fees are not set in stone and can be avoided. Look for bank offers designed for new account holders that promise no maintenance or yearly fees when meeting specific criteria, such as maintaining a minimum balance in your account.
Many banks charge penalties for several reasons. While these can generally be avoided, many people end up having to pay some of these fees during their lifetime.
- NSF Fees – A fee charged when checking accounts do not have enough funds to cover a transaction
- Overdraft Fees – A fee charged when the bank covers a transaction that goes over the funds available in your account. However, this can often be prevented if you’ve signed up for overdraft protection.
- Late Fees – A fee charged for late payments.
- Inactivity fees – A fee charged when there is no account activity in a specific timeframe.
- Early withdrawal fees – A fee charged when withdrawing funds before the maturity date.
Some banks also charge ATM fees when withdrawing from a cash machine. This tends to vary from one bank to another, with some banks charging no fee at all.
Some banks will also partner with ATM networks to offer no-fee withdrawals when using any of their cards.
Many banks offer some investment opportunities that can see you earn a higher return than a savings account.
These investment options are becoming increasingly popular and usually are either self-directed or managed. Generally speaking, these investment options can include stocks, commodities, and other forms of investments.
Either way, the bank will take a commission on the investments made by the customer. In most cases, this will be either in the form of a spread (when self-directed) or in the form of a fee when it is managed.
Many banks charge fees for processing applications, such as when applying for a loan.
These fees vary from one bank to another, with some banks waiving processing fees altogether or refunding them upon acceptance of the application.
Optional Service Management Fees
There are some other fees that the bank charges its customers. While many of these fees are for optional services, they can still provide the bank with an income source.
This is especially true for banks that have a lot of customers with different requirements.
- Check printing fees – Paid by the customer when requesting a cashier’s check.
- Money order fees – Paid by the customer when requesting a money order.
- Interchange fees – Paid by a merchant whenever a customer uses a credit card or debit card to make a purchase.
- Foreign currency exchange fees – The bank buys and sells foreign currency at different rates, taking a commission each time the currency is exchanged.
- Wire transfer fees – Paid by the customer when sending a wire transfer. In most cases, this is only applicable to international wire transfers.
Do note that not all banks will necessarily charge these fees. Some banks might offer specific services for free to all account holders or to customers who have a higher-tier account.
Credit Card Interest
Most banks also provide credit cards to their customers. When a balance is not paid in full on the due date, interest can accumulate quickly, with higher interest rates being relatively standard.
How Commercial Banks and Credit Unions Make Money
Credit unions and commercial banks play an essential role in the economy. Commercial banks offer different kinds of financial products and services to individuals and SMEs (Small and Medium Enterprises) such as freelancers and small businesses.
Products and services offered by commercial banks can include any of the following:
- Checking accounts
- Deposit accounts, including savings accounts and CDs (Certificates of Deposit)
- Bank loans
- Credit cards
- Cashier’s checks
These are not all of the financial services commercial banks offer since different banks can provide various services. This is especially true as banks expand what they offer to attract different types of customers.
Credit unions make money the same way commercial banks do. The difference is that credit unions are not-for-profit organizations.
This means they can charge lower fees since they are not looking to make money. Any profit credit unions make is either re-invested back into the credit union or paid out as dividends to its members.
From savings and checking accounts to personal loans such as auto loans and everything in between – banks need to make money to continue providing the services they do.
How To Keep Your Costs Down
So yes, as you can see, banks rake in huge profits. But this doesn’t mean that you have to pay all of the fees the bank charges. There are many ways to keep your costs down and even optimize what you earn from them. These include:
- Find bank offers and promotions: Many banks offer promotions that can help you save money. From free cash to higher APY rates, you can find different bank offers and promotions to suit your financial lifestyle.
- Make payments on time: Making payments on time can help you avoid many of the penalties banks tend to charge. If you have trouble budgeting, try using budgeting software to stay on top of what you owe.
- Keep a healthy credit score: It’s no secret that banks tend to offer better terms to those with higher credit scores. If you want to lower the amount of money you pay to the bank, keeping your credit score in check can help you do just that.