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Although we all use our bank accounts daily, most of us may not know how banks actually work. With checking accounts that pay you interest and free ATM services, how do banks make money? Well, you better believe banks are a business and profit is their top priority. Let's get into it!
Basically, banks don’t turn a profit until they have your money, so attracting and retaining clients is key for banking institutions. This is why they offer sign-up and referral gifts, waive fees for direct deposits, and provide benefits to high-value clients.
Like any business, banks have expenses and revenue streams that they strategically leverage in order to grow.
How banks make money
Banks are known for charging penalties or recurring fees to account holders, but the main way they make money is through loans. Below are the main ways in which banks make money.
1. Profits from debt interest
When you deposit your money in a bank account, the bank uses that money to make loans to other people and businesses to whom they charge interest.
The bank pays you a certain amount of interest in exchange for keeping your deposit. However, they collect more interest on the loans they issue to others than the amount of interest they pay to account holders like you. This, in turn, earns them a profit.
For example, your standard checking account might earn you 1% each month, but the bank is using those funds (pooled together with many other accounts’) to issue mortgages at 4%, student loans at 12%, and credit cards at 20%.
Whether it’s the interest you pay on your mortgage or the interest they earn by lending out the money you’ve saved with them, banks earn massive amounts of money on seemingly small percentage margins. Big banks can earn more than $50 billion each year on interest alone and similar amounts on other services and products.
By giving you pennies each month, the banking institution is earning millions.
2. Banking fees
Another way banks make money is through regular or case-by-case fees. These might include:
- Account “maintenance” fees which are generally charged to your account monthly just for being open. These are often avoidable and should be taken into consideration when choosing a bank or a particular account.
- Inactivity fees for not using your account often enough. Be sure to look into this before opening an account you plan to seldom use.
- Overdraft or insufficient fund charges when you spend more than you have in your account. You can avoid these by staying on top of your budget.
- Excessive withdrawal fees from savings accounts, which have monthly caps mandated by the federal government.
- Wire transfer fees if you want to send money to another bank or entity.
- Charges for paper statements if you opt not to receive online statements. Going paperless is more environmentally friendly, easier to track, and efficient anyway, so definitely consider this option.
- Debit card replacement fees for lost or stolen debit cards.
- ATM fees if you use certain ATMs outside of your bank's network.
- Bad check penalties if you deposit someone else’s bad check, even if you do so unknowingly.
- Minimum balance charges if your account balance falls below the minimum required balance.
3. Interchange fees
While swiping your debit or credit card is generally free to you, a transaction or processing fee called interchange is typically generated. This fee is charged by your bank to the merchant's bank (merchant being the store where you made the purchase) as a percentage of your transaction. The merchant's bank then deducts this fee and their own processing fee, from the cost of your purchase.
For example, the coffee shop where you buy your daily coffee might have to pay a transaction fee to the bank in order for your debit or credit transaction to be processed. In the process, the banking parties involved earn money from fees that the coffee shop has to pay. This is why sometimes you'll see minimum purchase requirements in certain stores, as these fees can add up quickly.
Expenses banks pay
As with any other business, banks also have their share of expenses they need to pay to keep things running. They include:
1. Non-interest expenses
About 15% of the cost of running a bank is “non-interest expenses,” with a median expense of about $400,000 for branches across the country. These costs include standard operational spending like employee salaries and benefits, equipment and IT, rent, taxes, and professional services like marketing.
2. Interest expenses
On the other hand, banks also have “interest expenses,” which are the cost of interest on loans they take out, just like you pay when you take out a loan. As mentioned earlier, banks might pay interest on deposits to their account holders, short-term and long-term loans they take out, and trading account liabilities.
What to consider when choosing a bank
When you deposit money in your bank account, you’re paying an “opportunity cost". This means, instead of investing that money yourself, you’re allowing the bank to earn a profit using your money. In exchange, you'll get a secure place to store your money and you'll earn a very small interest percentage.
As a result, deciding which type of bank and account works best for you and your money goals is an important decision. Once you do this, you can determine how much to put in the bank and how much to invest elsewhere.
Here are some key things to look for in a bank.
Make sure the bank is FDIC insured
The first thing you should look for in a bank is that it’s insured by the FDIC. If it is, that means you’re covered for losses of at least $250,000 if the bank goes out of business.
Review the banks' fees and associated costs
The next thing to look for is which fees the bank charges. Evaluate whether or not the fees apply to you, if the fees are worth it in exchange for any benefits, and if there’s a way to waive or avoid the fees.
Consider this: An $8 monthly maintenance fee over the course of 5 years is almost $500. If you think that $500 could be better spent or invested, make your choices accordingly. Fees are especially pertinent if you plan to have multiple accounts to manage your finances.
Decide on the type of bank you want
You’re not confined to the closest or best-known bank. While it may be useful to ask around, do your own research because many people choose a bank out of convenience, rather than digging into all the factors at play.
There are many options that each have their own pros and cons.
- Big Banks: These national giants have many branches and ATM locations, name recognition, and potential partnerships with other companies that could lead to perks for you as an account holder.
While their customer service might have extended hours, it might also be less personal because of the volume of clients they deal with daily. You are much more likely to have account fees with these larger banks.
- Local Banks: These community-focused banks might do more to give back and stimulate the regional economy. They also are likely to have more personal customer service and free checking accounts.
Their services might be limited compared to their bigger competitors, and if you travel often, you might miss the convenience of far-reaching locations.
- Credit Unions: Very similar to regional banks in service, credit unions have a not-for-profit structure and are owned by the customers. (Standard banks are investor-owned.) This means you become a partial owner when you open a credit union account and deposit money.
Small credit unions tend to have an easier loan approval process. However, these smaller institutions have less reach than the big names in banking.
- Online Banks: Having ditched the brick-and-mortar, online banks operate entirely on the web—this is both a pro and con depending on your relationship with technology. Online banking is often free and may even pay higher interest rates on accounts than traditional banks.
Still, it may be worth keeping an account with a physical bank or credit union, especially if you find yourself dealing with checks or cash often. Some big banks do offer online banking, so this might be a hybrid option for you. Two of our favorite online bank accounts include this one from Chime and this one from Credit Karma.
The good news is, there are plenty of choices out there to help you manage your money. The tricky part is figuring out which is the best fit. Don’t be afraid to shop around before committing. Even if they offer you a free account, that bank will be making a lot of money from your deposits, so you deserve the institution that feels right to you.