How Do Banks Make Money?

How Do Banks Make Money?

Have you ever wondered about how banks make money?

Banks make money from their retail customers, people like you and me, as well as from merchants: department stores, retail outlets, restaurants, bars, etc.

They charge customers interest on loans they provide, as well as service/account fees. They make money off of merchants every time a customer of that merchant uses a debit or credit card at its place of business; the fee merchants pay banks is called an interchange fee.

Below is a breakdown of the three big ways in which banks make money: net interest margin, interchange, and fees.

Net Interest Margin

Customers make deposits into banks and the banks typically use most of those deposits to provide loans (home, auto, student, etc) for other customers. These loans have interest rates tied to them that customers need to pay in order to get the loan in the first place.

This means that the money earned on these loans is revenue for the bank, and some of that earned money is given back to customers in the form of interest within checking and savings accounts. The money that the bank keeps is considered the net interest margin: put another way, the difference between how much the bank earns on their loans versus what they payback to customers is their net interest margin.

For example, someone can get a $100,000 mortgage from a bank, but it’ll come with an annual percentage rate (APR) that the customer needs to pay in order to get that loan. The APR is the cost to borrow $100,000 from the bank.

To illustrate, you can get a 30 year fixed rate loan for a 4% APR. On a 30 year loan, the customer will pay roughly $72,000 in interest to the bank. Then, the bank will give some of that earned interest to their customers’ checking and savings accounts. The amount left over is the banks’ net investment margin.

In reality, there are all sorts of loans with varying interest rates. Another common example is credit cards.

When people don’t pay off their credit cards in full, they are charged interest on the balance of their credit card. The APR that people pay for credit cards can range anywhere from 0% to upwards of 25%. The money (or interest) the banks earn on these unpaid credit cards is another example of  banks loaning out customers’ deposits, earning money on those deposits, paying some of that money back to customers checking and savings accounts, and pocketing the rest.

Interchange

Whenever you use a credit or debit card to buy something at a store, that store usually has to pay what’s called an interchange fee. Most of the interchange fee goes to your bank, and some goes to the store’s bank. This interchange fee covers the cost of handling credit and debit transactions.

Interchange fee rates are set by credit card companies. Among other factors, interchange fee rates can vary by provider, but the way in which they are structured is that it’s a percentage of the transactions plus a flat rate.

For example, if the interchange rate is 2.00% + $0.10, and someone bought a $100 item, the total interchange fee the store would pay would be $2.10. The store would get $97.90 of the actual purchase and the $2.10 interchange fee goes to the bank that provided you the credit card.

When you go into a store or restaurant and see that there is a card minimum, it’s most likely because of the interchange fee. The flat rate portions of the interchange fee for smaller transactions can really add up for businesses.

In the last few years, businesses have been fighting to lower the interchange fee rates and have had some success with capping interchange fees on debit card purchases.

Fees

Most people are familiar with banking fees. Banks find ways in which to charge their customers all sorts of fees. With many traditional banks, your checking or savings account agreement will have a long section listing out all the ways in which they charge you fees and penalties. If you’re curious, here is an example of a bank’s fee schedule.

Some common fees and penalties include: monthly service fees, minimum deposit limits, withdrawal penalties, ATM fees, overdraft fees, and foreign transaction fees.

Sometimes banks have so many fees, they have online guides on how to navigate all of the fees associated with your checking or savings accounts.

Some of the most common fees that people get hit with are ATM fees and overdraft fees. ATM fees have hit a record high for the 14th year in a row. Additionally, the average overdraft fee has increased virtually every year for the last 20 years.

Incentives don’t seem to be aligned for banks and customers when it comes to certain fees.

Banks could help prevent debit card overdrafts at checkouts and ATMs by denying the transaction or warning the customer, though doing so would eliminate the opportunity to charge the overdraft fee. Unsurprisingly, the majority of people would prefer that their debit card purchase get denied at checkout if it meant they would not get hit with an overdraft fee, according to the Center for Responsible Lending.

Traditional Banks vs Credit Unions vs Online Banks

Traditional banks are generally older, legacy banks that have actual physical locations and are for-profit institutions.

Credit unions are nonprofit institutions, member owned and have physical locations. Credit Unions usually require qualifiers for membership, which can include factors like: being part of a community group, a specific employer, or living inside of a geographic location.

Online banks are a newer type of bank that may not have any physical locations; everything is online via a website and/or an app.

There are some key differences between traditional banks, credit unions, and online banks when it comes to how they make money.

Generally, traditional banks will make money in all three ways: net interest margin, interchange, and fees. Traditional banks are notorious for lots of fees and often provide relatively lower interest rates to their clients’ in savings and checking accounts because they keep a large chunk of its net interest margin, have higher expenses, and are for profit.

Credit Unions, similar to banks, will also make money in all three ways: net interest margin, interchange, and fees. However, they’re generally able to provide higher rates on savings and checking accounts and charge lower fees relative to larger banks. They’re able to do this because of their non-profit structure, size, and selective membership.

Online banks will make money in all three ways as well, but since they don’t have physical locations, they’re often able to provide higher interest rates on savings and checking accounts. Additionally, many online banks have less fees relative to traditional banks and credit unions.

The Bottom Line

To recap, banks can typically make money in three ways: net interest margin, interchange, and fees. Traditional banks, credit unions, and online banks make money in utilizing all or a combination of the three methods. By better understanding how banks make money, you might find yourself learning how to look out for fees and understand if banks are truly working in your best interest.

Author: Deepak

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