How Do Banks Make Money?
While everyone needs to use bank services for one thing or another, most people don’t really know how banks actually work. With accounts that pay you interest, investment portfolios that are supposed to generate profit for you, free ATM usage, and so on, it can become hard to understand what banks take from offering you all these services. But no need to worry about them, being a bank is a business – and a good one.
Even though many mask it quite well, profits are the top priority of banks, and they only start making it once they have your money. Thus, attracting and retaining clients is key for banks to work well. Just like any other business, banks have expenses and revenue streams that they strategically leverage in order to grow.
Taking all that into consideration, it is important to understand how banks make money. This way, you can make financial decisions based on the power you actually hold as a client. On top of that, there are some alternatives to traditional banks that make their profits in slightly different ways. These alternatives often scrape less yield than banks, giving better conditions for your finances.
So, stick to this article to learn all the above vital information and more on how banks make money.
What Is a Commercial Bank?
This article refers to how commercial banks make money, not other types of banks such as Central Banks. Thus, before jumping into the ways banks make money, it is interesting to understand what commercial banks are.
A commercial bank is a financial institution that accepts deposits, provides checking account services, makes various loans, and provides basic financial products to individuals and small companies. Some examples of these financial products are certificates of deposit (CDs), savings accounts, and stock investment. Most individuals conduct their banking at a commercial bank.
How Banks Make Money
Nowadays, banks became quite creative in the way they make money. They manage to scrap some profit from many layers of their structure, taking advantage of any opportunity they can find to grow their business. However, it is possible to highlight four main ways in which banks make money:
Profits from Debt Interest
When you deposit money in a bank account, the bank utilizes your funds to offer loans to other individuals and businesses. These people or companies that borrow money from the bank are charged an interest rate.
Part of this interest is paid to you, in exchange for maintaining your deposit in the bank. However, the share of interest passed to you is way smaller than the yield they receive from the borrower. The result of this dynamic is a very good profit for the bank and a small interest rate for you.
This is an example to make it clear to you how lucrative this dynamic is for the bank. Your typical checking account may yield you 1% per month. But the bank is utilizing the money you deposited in it (along with funds from other accounts) to issue mortgages at 4%, school loans at 12%, and credit cards at 20%.
Banks gain huge sums of money on apparently little percentage margins - whether it is the interest you pay on your mortgage or the income they get by lending out the money you've saved with them. Big banks may make more than $50 billion in interest alone each year. Then, they also make equivalent amounts earned on other services and goods.
The banking organization earns millions by paying you pennies every month. On top of that, the interest rates of checking accounts, savings accounts, certificated of deposits (CDs), and other financial products offered by banks are becoming lower each year. Nowadays, most savings accounts from traditional banks don’t even offer an interest rate that repays you the inflation rate. Thus, at the end of the day, you might be losing money to an institution that is making enormous profits.
You can avoid receiving such a small share of the interest rate by using alternatives to traditional banks. An option is online banks, which offer greater and often more transparent interest rates. Another alternative is crypto-based savings accounts, which provide extremely competitive yielding to its customers due to its different model of business.
Banking Fees
The most direct way banks make money is through banking fees. These can be regular or case-by-case fees and can come in many names and formats of charges. Banking fees might include:
Account Maintenance Fees: These are often charged to your account on a monthly basis simply to keep it open. Maintenance fees are preventable and should be considered before selecting a bank or a specific account.
Minimum Balance Fees: If your account balance goes below the minimum necessary level, you will be charged a minimum balance fee. However, this is an avoidable fee since most online banks and crypto-based accounts don’t require a minimum balance. When they do, it is as low as $10. Thus, check this information before choosing your bank.
Inactivity Fees: These are the charges for not using your account often enough. Check into this before establishing an account that you don’t plan on using much. Many banks don’t charge these, making them very avoidable fees.
Overdraft or insufficient fund charges: When you spend more than you have in your account, you will incur overdraft or insufficient fund charges. Staying on top of your budget will help you prevent them.
Excessive Withdrawal Fees: These are fees most commonly found on savings accounts, due to monthly limits imposed by the federal government (which are not currently being imposed because of the pandemic’s financial impact). However, some banks also charge these on checking accounts to prevent their customers take too much money from their accounts.
Wire Transfer Fees: It is a type of fee that applies if you need to move money rapidly to another bank or entity. These transfers are usually made on the same day. It is not the same as ACH transfers, which might take several days, for example.
Debit Card Replacement Fees: Charges for replacing debit cards that have been lost or stolen.
ATM Fees: They may apply if you use an ATM that is not part of your bank's network. Keep an eye if the bank you chose charges ATM fees since many online banks don’t.
There are other fees that banks might apply, such as bad check penalties and charges for paper statements. Some of these fees are unavoidable and you will probably have to pay for them regardless of the bank you choose.
You can avoid, however, many of these fees. Maintenance, minimum balance, inactivity, excessive withdrawals, wire transfer, and ATM fees can be avoided by choosing a financial institution that doesn’t charge them. Online banks, for example, tend to have lower to no fees. Crypto-based companies that often services similar to banks also tend to don’t charge fees. With these, you will probably only have to pay very small flat transaction fees to deposit or take out your money.
Interchange fees
While using your debit or credit card is normally free, a transaction or processing fee known as the interchange is usually charged. This fee is levied as a percentage of your transaction by your bank to the merchant's bank (the merchant being the store where you made the purchase). This amount, as well as the merchant's own processing fee, is then deducted from the cost of your transaction by the merchant's bank.
For example, in order for your debit or credit transaction to be processed, the restaurant where you eat may have to pay a transaction fee to the bank. The financial parties involved profit from the fees that the restaurant must pay. This is why, at certain businesses, there are minimum purchase restrictions, as these fees may quickly mount up.
Unfortunately, these fees are harder to avoid as a consumer. As a company, there are some banks that don’t charge this type of fee, especially alternative banking services that are disrupting the industry.
Alternatives to Traditional Banks
By now, you must have noticed how customers are not winning in the dynamic with banks. Fortunately, many new banks and institutions came changing a little – or a lot – how the industry works. These are online and crypto-based financial institutions. Even though some still make money from lending your funds to others, they tend to scrape less interest from the customer. This results in you having access to way better yield. Thus, if you are looking for some alternatives to traditional banks, here are some to take a look at:
