In news that will surprise no one: Banks are businesses. And like most businesses, they want to make money. But banks can’t keep the lights on or pay their employees by ATM fees alone. So, how do banks make a profit?
When you break it down, banks make money off of your – and other people’s – money. But, of course, it’s more involved than that.
Types of Banks
There are several types of banks, including commercial banks, investment banks, online banks and credit unions. No matter the type, most banks have this in common: they accept deposits and give out loans. Depositors and borrowers can be individuals, businesses, governments and other banks.
Commercial bank definition
When most of us think of banks, we usually think of a credit union (essentially, a nonprofit bank) or an online bank. Either would make sense because both fall under the definition of a commercial bank. A commercial bank is a bank that people and businesses use for their day-to-day needs.
Typical commercial bank products and services include savings and checking accounts, loans – like mortgages, auto loans and lines of credit – and credit and debit cards. Some banks offer safety deposit boxes and wealth management services.
How do banks make their money?
On average, commercial banks make a profit on 1% – 2% of their total assets. This is commonly known as the bank’s return on assets. Banks generate this income from three main sources: interest income, fees and income from capital markets.
Commercial banks mostly make money by collecting more interest on debt than they pay out to depositors (think: people or companies that keep money in a bank checking, savings or other deposit account).
Banks offer depositors (aka bank customers) an interest rate on the money they deposit. Basically, the bank pays depositors for keeping their money with 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, auto loans, business loans, college loans and personal loans.
IRL, it might look like this: A bank offers its checking account holders a 1% monthly interest rate but offers its mortgage loan borrowers a 5% interest rate. That’s a 4% profit for the bank.
Think of this “cycle” as a 4-step process:
- You deposit your money into your bank account. 💰⃕ 🏦
- The bank pools all of its deposited money and loans it out. 💰 + 💰
- Borrowers pay the bank interest to borrow the money. 💵 → 🏡
- The bank pays the depositor interest for keeping their money with the bank. 🏦 → 😎
Are you wondering how you can withdraw your money even though the bank is hard at work lending it out? Let’s take an explanatory pause.
Banks don’t lend out everything they have. The Federal Reserve Board requires that banks keep a certain amount of money in reserve. Plus, the Federal Deposit Insurance Corporation (FDIC) or 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 a securities firm. The buyers package the loans into mortgage-backed securities for investors. Selling off loans frees up money for banks and allows them to continue lending.
Even after a bank packages and sells its loans, the bank can keep making money. If the bank is used to service mortgages (think: handle the administration of a loan) it can charge the new lenders servicing fees.
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 most common bank fees are:
- Account maintenance fee: Some banks charge a monthly service fee, usually $5 – $25, for keeping your money with them.
- ATM fee: You know that feeling when you need money real bad, but the only available ATM is “out of network”? It means you’re withdrawing from an ATM that isn’t run by your bank or its partners and that usually means hefty ATM fees. You might even have to pay an ATM fee and a fee to your bank. It could end up costing you $4 to take out your money.
- Overdraft fee: Customers can opt for overdraft protection. It lets a payment or withdrawal go through if you don’t have enough money in your account to cover it. The bank covers the overdrawn amount. You’ll have to pay back what the bank covered and a fee that can cost up to $35 a transaction.
- Insufficient funds fee: You didn’t opt for overdraft protection? If you try to make a payment or withdrawal for more money than you have in your bank account, you may get an insufficient funds fee from your bank (generally up to $35 a transaction), and you may have to pay a fee from the person or business you were trying to pay.
- Card replacement fee: You need a new card because you either lost your debit or credit card, or you used it so much that it wore out. Some banks won’t charge you for a replacement – but some will. It can cost around $5 – $7 to replace a card. And if you need the new card right away, it could cost $25 or more for rush delivery.
- Excessive withdrawal fee: These fees are usually charged on nonchecking accounts, like a money market fund or savings account. You’ll be charged an excessive withdrawal fee for every withdrawal you make that goes over your monthly withdrawal maximum. Depending on the bank, it can be a $5 fee or a $25 fee.
Banks also make money on interchange fees. This is the fee a bank charges a business’s bank for processing a credit card transaction.
Let’s say you own a credit card from your local commercial bank, and you use that card to pay for groceries at 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 money (like any market).
The products 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 the bond market.
Banks can invest part of their assets in capital markets and generate income on those investments. These investments are mostly in the form 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 reduce the cost of your everyday banking with a few simple actions, including:
- Keeping track of your balances: Make sure you know how much money you have in your checking or saving account(s) to help avoid overdraft and/or insufficient fund fees.
- Looking for fee-free services: Some banks offer basic accounts with no minimum balance or maintenance fees.
- Assessing credit card annual fees: Sometimes the benefits and rewards you get with a credit card far outweigh the annual fee. But does that check out in your case? Would switching to a card without an annual fee work just as well for your needs?
- Comparison shopping for loans: When you’re getting a loan, like a mortgage or auto loan, even a small difference in interest can translate into hundreds or thousands in savings over the life of the loan. Get rate quotes from several lenders and make it your business to know their fees.
Choosing a Bank
Banks provide services that people and businesses need, and they keep our economy going. To build a mutually (and monetarily) beneficial relationship with your bank, evaluate a bank’s terms and fee structure to make sure it’s right for you – and your money.
International Monetary Fund. “Banks: At the Heart of the Matter.” Retrieved January 2022 from https://www.imf.org/external/pubs/ft/fandd/basics/bank.htm