In news which will surprise no one: Banks are businesses. And like the majority of businesses, they would like to make money. But banks can't keep your lights on or pay their employees by ATM fees alone. So, how can banks earn profits?
When you break it down, banks make money off of your – along with other people's – money. But, of course, it's more involved .
Types of Banks
There are several types of banks, including commercial banks, investment banks, online banks and lending institutions. Regardless of type, most banks have this in keeping: they accept deposits and provide out loans. Depositors and borrowers could be individuals, businesses, governments and other banks.
Commercial bank definition
When most of us consider banks, we usually think of a bank (essentially, a nonprofit bank) or perhaps an online bank. Either will make sense because both fall under the phrase an industrial bank. An industrial bank is a bank that people and businesses use for his or her day-to-day needs.
Typical commercial bank products and services include savings and checking accounts, loans – like mortgages, auto loans and contours of credit – and credit and debit cards. Some banks offer safety deposit boxes and wealth management services.
How do banks make their cash?
On average, commercial banks make a profit on 1% – 2% of the total assets.[1] This is often called the bank's return on assets. Banks generate this income from three main sources: interest income, fees and income from capital markets.
Interest income
Commercial banks mostly earn money by collecting more interest on debt than they pay out to depositors (think: people or firms that keep money in a bank checking, savings or other deposit account).
Banks offer depositors (aka bank customers) mortgage loan around the money they deposit. Basically, the bank pays depositors for keeping their money using the bank. But the adventure doesn't end there.
Banks pool their depositors' money and lend it to borrowers at a higher interest rate for mortgages, automotive loans, business loans, college loans and private loans.
IRL, it could look like this: A bank offers its checking account holders a 1% monthly interest rate but offers its home loan borrowers a 5% rate of interest. That's a 4% profit for the bank.
Think of the \”cycle\” as a 4-step process:
- You deposit your hard earned money into your banking account.
- The bank pools all its deposited money and loans it out. +
- Borrowers spend the money for bank interest to borrow the cash. →
- The bank pays the depositor interest to keep their money using the bank. →
Are you wondering the best way to withdraw your hard earned money although the bank is hard at the office lending it? Let's take an explanatory pause.
Banks don't lend out everything they've. The Federal Reserve Board requires that banks keep a specific amount of money in reserve. Plus, the Federal Deposit Insurance Corporation (FDIC) or even the National Credit Union Administration (NCUA) insures and protects your money.
Banks can also raise money by selling their mortgage loans to Fannie Mae and Freddie Mac or perhaps a securities firm. The buyers package the loans into mortgage-backed securities for investors. Selling off loans releases money for banks and allows them to continue lending.
Even following a bank packages and sells its loans, the bank can keep earning money. If the bank is used to service mortgages (think: handle the administration of the loan) it can charge the new lenders servicing fees.
Fee-based income
If you've suspected that banks make beaucoup money off of those fees you've encountered during your banking experience, you'd be right.
Some of the very most common bank fees are:
- Account maintenance fee: Some banks charge a regular monthly service fee, usually $5 – $25, for keeping your hard earned money together.
- ATM fee: You know that feeling when you really need money real bad, however the only accessible ATM is \”out of network\”? It means you're withdrawing from an ATM that's not run by your bank or its partners which usually means hefty ATM fees. You may even need to pay an ATM fee along with a fee to your bank. It might wind up squandering your $4 to get your hard earned money.
- Overdraft fee: Customers can opt for overdraft protection. It lets a payment or withdrawal go through without having enough profit your account to cover it. The financial institution covers the overdrawn amount. You will need to pay back exactly what the bank covered along with a fee that can cost as much as $35 a transaction.
- Insufficient funds fee: You didn't opt for overdraft protection? By trying to make a payment or withdrawal for more money than you have inside your bank account, you might get an insufficient funds fee out of your bank (generally up to $35 a transaction), and you'll have to pay a charge from the person or business you had been trying to pay.
- Card replacement fee: You require a new card since you either lost your credit or debit card, or else you tried on the extender so much it wore out. Some banks won't charge you for a replacement – however, many will. It may cost around $5 – $7 to replace a card. And if you need the new card immediately, it might cost $25 or even more for rush delivery.
- Excessive withdrawal fee: These fees are usually charged on nonchecking accounts, like a money market fund or checking account. You'll be charged an excessive withdrawal fee for every withdrawal you are making which goes over your monthly withdrawal maximum. With respect to the bank, it's really a $5 fee or perhaps a $25 fee.
Interchange fees
Banks also earn money on interchange fees. This is actually the fee a bank charges a business's bank for processing a credit card transaction.
Let's say you have credit cards out of your local commercial bank, and also you use that card to pay for groceries in the supermarket. Your bank will collect a percentage of that transaction as an interchange fee.
Capital market income
In a capital market, products and/or services are exchanged for the money (like any market).
The goods are financial assets – like stocks, bonds and currencies – and they are exchanged by financial institutions or institutional investors and individuals, businesses or governments. The two best-known capital markets are the stock market and also the bond market.
Banks can invest part of their assets in capital markets and generate profits on those investments. These investments are mainly by means of U.S. government bonds.
Banks are bound by strict regulations that dictate how much they can invest. This ensures that they don't risk too much money and risk their customers' assets.
Minimizing Your Banking Costs
You can help to eliminate the cost of your day-to-day banking with some simple actions, including:
- Keeping tabs on your balances: Make sure you are aware how much cash you have inside your checking or saving account(s) to assist avoid overdraft and/or insufficient fund fees.
- Looking for fee-free services: Some banks offer basic accounts without any minimum balance or maintenance fees.
- Assessing credit card annual fees: Sometimes the advantages and rewards you receive with a credit card far outweigh the annual fee. But does that take a look at in your case? Would switching to a card with no annual fee work just as well for your requirements?
- Comparison shopping for loans: When you're obtaining a loan, just like a mortgage or car loan, even a small improvement in interest can translate into hundreds or thousands in savings within the life of the loan. Get rate quotes from the 3 lenders and make it your business to understand their fees.
Choosing a Bank
Banks provide services that people and businesses need, plus they keep our economy going. To build a mutually (and monetarily) beneficial relationship together with your bank, evaluate a bank's terms and fee structure to make sure it's best for you – as well as your money.
