How Do Banks Make Money?

We can see ancient people using a barter system long back in history. In medieval times we had feudalism and mercantilism. After a brief period, the concept of money came into action which became a boon to the people. The governments established banks to perform transactions and keep people’s money safe. Has anyone ever imagined during the 1600s that people would use banking services?

Today, banks are an integral part of one’s life. Whether it be a savings account, Demat account, or Insurance account, banks are our go-to place. Most of us are always thrilled to look for checking accounts with minimum charges and free ATM services. But have you ever wondered how banks make money?

While most of us would not realize how banks work, they are centralized business entities present for business. Banks make a profit by attracting and retaining clients. It is a crucial factor for banking institutions which is why they offer a sign-up bonus, referral gifts, and fee waivers. Even banks have expenses to pay to their employees and make a revenue stream to grow in the banking space. Let’s decode how banks make money in this article.

What Mechanism Do Banks Follow For Making Money?

Not just one, banks make money in numerous ways, which most people are unaware of. Banks charge penalties on checking accounts and extract recurring fees from the account holders. They actively charge interest on loans and many fees to make money.

1. Interest on Debt

Most people would have savings accounts for keeping money that banks use to lend money (in the form of loans) to other people and businesses to which they charge interest. The banks pay up a specific interest to people who open a savings account. They charge higher interest to people who take loans and issue less interest to savings account holders. The difference in interest rates helps banks earn profit.

Example: Consider you have a savings account in XYZ bank that helps you earn 7%. The bank uses your funds and issues personal loans at 18% and credit cards at 20%. This vast difference helps banks earn a decent profit when pooled together with other accounts.

So, even if the interest difference might look small to you, banks combine all the money from different accounts to earn significant interest on cash. It may be astonishing to know that big banks clock more than $50 billion every year on interest and other banking products. In short, banks make millions by using your money and paying you pennies in return.

2. Banking Fees 

Banking fees are no rocket science as every bank has a ‘Fees and Charges’ section (which most of us ignore). One, two, three, and the areas are never-ending, which is one of the biggest ways banks make money. Let’s get to know about some of them:

i. Account Maintenance Fees: Banks usually charge fees monthly or annually for using their banking account. While some banks offer no-fee accounts upon meeting specific requirements, some banks may charge you $x a month to maintain the account. Hence, it is essential to choose the bank wisely to avoid paying maintenance fees to your bank. 

ii. Overdraft or Insufficient Fund Charges: If you plan to make a purchase higher than your bank balance, you will have to pay an overdraft fee to the bank. It is a popular way banks make money as people tend to buy products in flash sales. To avoid paying an overdraft fee, keep an eye on your bank balance and avoid spending more than your budget permits. 

iii. Excessive Withdrawal Fees: Avoid withdrawing excessive amounts from your bank account as there are different regulations on savings accounts than checking accounts. Banks make money when people exceed the monthly transfer cap (without noticing). It is essential to be aware of the cost and avoid paying fees to the bank. 

iv. Inactivity Fees: If you do not use your bank account often, your account goes inactive (or dormant), resulting in fees. The best way to avoid paying inactivity fees is by making a deposit or withdrawing money from your account regularly. 

v. Wire Transfer Fees: Wire transfer helps to send money to another bank or entity quickly. Unlike ACH transfers that take a few days, wire transfers typically happen on the same day. It is essential to check the fees for wire transfers as they depend on transfers (domestic or international) and vary on the financial institution.

vi. Paper Statements Charges: It is an avoidable charge as you can always opt for paperless statements. They are more convenient, environmentally friendly, and efficient to track. It is important to cross-check the charges with your bank. 

vii. ATM Fees: Another way that banks use to make money is by charging customers who use certain ATMs outside of the bank’s network. The best you can do is use your bank’s ATM or take out enough cash prior.

viii. Minimum Balance Charges & Debit Card Replacement Fees: If you do not maintain a minimum balance as prescribed by your bank, you are liable to pay a penalty fee. Do proper research and choose the bank account that provides zero balance accounts. While some banks offer a free-of-cost replacement for lost or stolen debit cards, some banks might charge you a fee for giving another debit card. 

3. Transaction Fees

We all must have swiped our debit or credit card at our favorite outlet while shopping. While you might now be aware of the process happening in the backend, banks typically charge a transaction or processing fee to the merchant’s bank as a percentage of your transaction. The merchant deducts the fee and their processing fee from the cost of your purchase.

What are the Expenses that Banks Pay?

The banks have to pay their share of expenses to provide you with services and keep the business going. The costs come into two sections: Non-interest expenses and Interest expenses. The former prices include standard operational spending like employee salaries and benefits, equipment and IT, rent, taxes, and professional services. In contrast, the latter include expenses banks pay for interest on deposits to their account holders, trading account liabilities, and short-term and long-term loans.

How Can You Save Your Money?

Typically speaking, banks survive as a business because they earn from several fees charged to the customer. When you deposit money in a bank account, they can profit using your money. The perks you receive are minimal compared to how banks utilize your cash for their good. However, with proper research, you can check the type of account that works best for you to save on fees and services.

The key factors include reviewing the banks’ fees and costs to avoid paying them to banks. You can check if your bank is FDIC insured as it helps to cover losses (of at least $250,000) if the bank goes out of business. Do proper research before opening a bank account, as you might be astonished to find that a bank might provide you with better options and fewer fees based on your requirements.

Generally, big banks provide an option of better customer service, ATM locations, and personal banking services. Choosing big banks over local banks might also help you take advantage of online services through a mobile app. Additionally, it is crucial to monitor your account balance and keep a close eye on transactions. You may also set up automatic payments to avoid paying overdraft fees or other fees as humans are prone to error. It also helps to maintain the proper balance to avoid minimum balance charges.

Avoid buying excessive stuff you might regret later for exhausting your overdraft limit. The bank charges an overdraft fee, so it is better to live within your means. You can build an emergency fund to help you serve in crucial moments. You can also save money by using free services such as free savings accounts, money transfers, and certain accessible ATMs. Ensure good money management practices by paying off your credit card in full every month to minimize interest payments. The small steps towards financial literacy will help you save on fees and safeguard your financial wellbeing.

Final Thoughts!

The banking sector has jumped to great heights in recent times, and you can easily witness plenty of choices to manage your money. You can compare different banks and their services to save your money by doing proper research. Do not blindly fall into the trap of all zero-balance accounts, as they might make a lot of money from your deposits. Always research and read about the charges before choosing the financial institution best for you!!