How Do Banks Make Money?

How do banks make money

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 do banks make money exactly?

Banks make money by charging penalties or recurring fees to account holders. However, the main way they make money is through loans. Below are the main ways in which banks make money.

1. Banks make money from interest on debt

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 (One of the biggest ways how banks make money)

So, how do banks make money with fees, and what types of fees do they charge? There are quite a few different fees that banks charge; here are fees you pay out of pocket to your bank:

Account “maintenance” fees

Banks make money by charging monthly service fees. For instance, they may charge a monthly fee of $13.95 a month to maintain the account. Some banks offer no-fee accounts or will waive these fees if you meet certain requirements, such as setting up direct deposit or having a minimum balance. Be sure to do research to find the best bank without fees so you can keep more money in your pocket!

Inactivity fees

If your account goes inactive, also known as "dormant," it will begin to accrue fees. You can avoid this simply by making a deposit or withdraw, so there is activity on your account. Be sure to look into this before opening an account you plan to seldom use.

Overdraft or insufficient fund charges are another way banks make money

Banks make money by charging insufficient fund fees. Every time you spend more than you have in your account, banks will charge an overdraft fee. This is another way how banks make money.

You can avoid these by staying on top of your budget. If you did make a mistake and have a good relationship with your bank, you can ask for the fee to be refunded, but this isn't something they do often.

Excessive withdrawal fees

There are different regulations on savings accounts than checking accounts. Savings accounts have monthly caps on transfers and withdrawals mandated by the federal government known as Regulation D.

So do your best to leave your money in your savings without tapping into it too much. This will help you avoid fees and depleting your savings accounts too.

Wire transfer fees

You can use wire transfers if you want to send money to another bank or entity quickly. These transfers typically happen on the same day. It is not the same as ACH transfers which can take a few days etc. Fees depend on if the transfer is domestic or international and also vary depending on the financial institution.

Charges for paper statements

Some banks may charge for paper statements. Also, if you need to request archived statements, this can mean additional fees as well. Going paperless is more environmentally friendly, easier to track, and efficient anyway, so definitely consider this option.

Debit card replacement fees

Some banks may charge for lost or stolen debit cards. Although it may not be super costly, it's still another fee you can avoid with the right bank.

ATM fees

If you use certain ATMs outside of your bank's network, it can cost you fees from your bank and the bank's ATM you are using! Avoid paying these fees by using your banks ATM's or take out enough cash, so you don't have to access another institution's ATM.

Bad check penalties

There are two types of bad check penalties. The first is if you "bounce" a check which means you don't have enough funds to cover the amount of the check. If you deposit someone else’s bad check, it will cost you a fee as well, even if you do so unknowingly.

Minimum balance charges

Minimum balance charges are another way how banks make money. So if your account balance falls below the minimum balance, then they will charge you a penalty fee. It's best to find accounts that have zero minimum balances, so you have one less thing to worry about and pay for unexpectedly.

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. Banks make money by charging this fee to the merchant's bank (the 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. A good example is black-owned banks. 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.

Now you know how banks make money!

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.

Learn how to be financially savvy by organizing your finances, creating a budget, and more with our completely free "Build a solid foundation course!" Don't forget to tune into the Clever Girls Know podcast and YouTube channel for all things personal finance!

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