How Do Banks Make Money?

Have you ever asked yourself how banks declare million and billions in profit at the end of each year? How do banks make money?

Banks make money in various ways, ranging from retail customers, people like me and you, from merchants, including bars, restaurants, retail outlets, department stores, etc.

Banks also charge their customers interest on the loans they provide and also account/service fees. They make money off merchants each time a customer of that merchant uses either a credit or debit card at their place of business; the fee merchants pay these banks is called an interchange fee.

How Do Banks Make Money?

Typically, banks make money in three primary ways: interchange, net interest margin, and fees. Below are breakdowns of the three primary ways in which banks create money. Banks can attract deposits by paying little or no interest on deposits for various reasons, including that adult businesses need one or more bank accounts. There are two ways that banks can make money with a free current account. Banks can also make a lot of money by charging interest to borrowers, and many banks do this. If a bank charges a fee for lending or paying customers to hold money for them, they can make a significant proportion of the money.

Banks make money in hundreds of ways. And there are many account fees that banks charge to make money from their customers. One of the most annoying ways a bank makes money is through charges, particularly ATMs and overdraft fees. The fee is just one way banks make money for their depositors. There are many other ways banks making money from their customers. One of these ways is interests, that the bank does not pay to its depositor in the same way. Another example of how banks make money from debit cards and personal checks is “charge” (mainly for overdrafts).

Where Do Banks Get Their Money?

1.   Net Interest Margin

Customers make deposits into banks, and banks typically use most of these deposits to make loans available (student, auto, home, etc.) for other interested customers. These loans are made available for other customers having interest rates attached to them, which the customers need to pay them to receive the loan in the first place.

This process means that the interest earned from these loans is profit for the bank. Some of these earned interests are given back to customers in interest within savings and checking accounts. The bank considers the money kept as the net interest margin. You call the difference between the amount the bank gains on their loans versus what they pay back to customers the net interest margin for better understanding.

For example, a customer can obtain a $100,000 mortgage from a bank. However, it will come with an APR (annual percentage rate) that the customer needs to pay for them to get the loan. The annual percentage rate is the cost charges to borrow $100,000 from the bank.

To illustrate this clearly, you can obtain a 30 year fixed rate loan for a 4% annual percentage rate (APR). The customer will pay approximately $72,000 in interest back to the bank on a 30-year loan. The bank will then grant some of that obtained interest to their customers’ savings and checking accounts. The net investment margin is the amount leftover in the bank.

Although, in reality, there are all kinds of loans that come with varying interest rates. Another familiar example is credit cards.

When people don’t fully pay off their credit cards, they charge them the interest in their credit card balance. The annual percentage rate people pay for credit cards can vary anywhere from 0% to 25%. The interest earned by banks on these unpaid credit cards is another significant example of banks loaning out customers’ deposits and making money from those deposits, reimbursing some of the money back to customer’s savings and checking accounts, and pocketing the rest, which to them is a profit.

2.   Interchange

Whenever you use either a debit or credit card to purchase commodities at a store, the store usually pays an interchange fee. The majority of the interchange fee goes directly to your bank, while some also go to the store’s bank. This interchange fee covers the cost of handling debit and credit transactions.

Credit card companies fix the rates of these interchanges. Among other factors, the rates of these interchange can differ by the provider; however, they structure it as a flat rate plus the percentage of the transactions.

For example, if the exchange rate fee is 2% + $0.10, and somebody purchased an item worth $100, the cumulative interchange fee for the store would be $2.10, leaving the store with $97.90 of the original purchase. The interchange fee of $2.10 goes to the bank that gave you the credit card.

When you walk into a restaurant or store and notice a card minimum, it is most likely to be so because of the interchange fee. The flat rate percentages of the interchange fee for lesser transactions can add up for businesses.

For the past few years, many businesses have been protesting to reduce interchange fee rates. There had been some glimpses of success, especially with the capping interchange fees on debit card purchases.

3.   Fees

The majority of people are already familiar with banking fees or charges. Banks always find a means by which they will charge their customers all kinds of fees. For many traditional banks, your savings or checking account agreement usually consists of a long section enumerating how they charge you penalties and fees. If you are curious about this, you can check a bank’s fee schedule.

Some of these banks’ common penalties and fees include foreign transaction fees, overdraft fees, ATM fees, withdrawal penalties, minimum deposit limits, and monthly service fees.

Some of the standard fees that bank customers get hit with are overdraft fees and ATM fees. The average overdraft fee has virtually increased every year for the last 20 years. Also, the ATM fees have already hit a high record for the 14th year in a row. Incentives don’t appear to be aligned for banks and customers when it comes to some particular fees.

Banks could help prevent debit card overdrafts at ATMs and checkouts by simply denying the transaction or cautioning the customer. However, doing so would eradicate the chance for banks to charge the overdraft fee.

Unsurprisingly, most people would like their debit card purchase to get denied at checkout if it meant that they would not get hit with an overdraft fee.

Where Do Banks Put Their Money or What Do Banks With Your Money?

There are several ways banks can generate revenue, including investing your money and charging customers fees. As banks offer asset management services to their customers, they can benefit from fees for these services and levy fees on certain investment products such as mutual funds. Banks take deposits from customers and borrow money from account holders, and they also lend money to other customers. At the same time, banks can charge higher interest rates to customers who take out home loans, car loans, student loans, business, and personal loans. The most significant way banks make money is by minimizing the interest they pay on your deposits. In banking jargon, you may know this as maximizing the net interest margin (explanation above). And it’s a fancy way to say they make money from your money but don’t pass it on to you.

Investment Banks

What is an Investment Bank?

Investment banking is a branch of the banking industry that focuses on raising capital for companies, governments, and other companies. Investment banks are a type of bank active in high finance to facilitate companies’ access to capital markets such as equity and bond markets. They do this for private companies, but they also subscribe to bonds and equity securities, assist in mergers and acquisitions, provide financial advice, provide IPOs and assist companies in initial public offerings. Full-service investment banks offer a wide range of services, including underwriting, M & A, sales and trading, equity research, asset management, commercial and retail banking. Most investment banks maintain a world-class brokerage and asset management department in conjunction with their investment research business.

How Do Investment Banks Make Money?

One of its main activities is to raise money by selling securities such as stocks and bonds to investors such as high net worth individuals and organizations such as pension funds. They also earn their money selling services to companies, governments, and investment funds and making money from consumers. Investment banks try to generate risk-free profits using their advanced investment know-how. After years under the investment bank’s scanner, people believe investment banks make large sums of money and paying obscene bonuses to their top management to act accordingly.

Commercial Banks

What Is A Commercial Bank?

Commercial banks focus on products and services designed for businesses, such as deposit accounts, credit lines, trading services, payment processing, commercial loans, global trading services, financial services, and other business-oriented products. Commercial banks help small businesses through corporate banking and large companies through investment banking. They also work with individuals and consumers by acting as retail banks.

How Do Commercial Banks Make Money?

Commercial banks make profits by offering interest-bearing loans to their customers in the form of interest income. Commercial banks are for-profit companies that pay lower interest rates to depositors and charge borrowers higher interest rates – that’s how they make a profit. In addition to primary investment products such as savings accounts and checking accounts, commercial banks also offer a range of financial services to the general public, such as accepting deposits and granting loan advances to customers.

Which Assets Include The Commercial Banking System?

Banks’ assets include banknotes and coins held by bankers in their vaults, deposits with the central bank, and part of banks’ reserves. The primary liability of commercial banks deposits, while the primary assets are loans and bonds. Commercial banks provide customers with demand terms, types of loans, and adequate security.

The Bottom Line

Banks make money in three primary ways, namely: interchange, net interest margin, and fees. Other financial platforms like online banks, credit unions, and traditional banks usually make money, using all or a combination of the three means.

To better understand how banks make money, you might need to learn how to look out for fees and truly understand if banks are working in your best interest.