Most of us wonder at some point about how a bank makes a profit. How do banks make money when they provide so many free service offerings — especially ones that yield dividends on your deposit? The principle is actually quite simple.
Banks sell products and services just as all other businesses do. They offer money storage and safety, ease of access to your cash, and the ability to save and/or invest as their primary services. Banks are able to turn a profit by investing your money, charging account fees, and providing other financial services, and they are very successful in doing so. The American banking market is the most profitable in the world, profiting hundreds of billions of after-tax dollars each year.
Below, you will learn the three basic ways that banks make a profit: fees, net interest margin, and interchange.
Based on findings from CNNMoney, banks profited $6 billion from overdraft and ATM fees alone in 2015, which was only between 5% and 20% of their revenue that year. Accountholder fees and service fees are a major contributor to bank profitability. Even though they’ve become easier to avoid, there will inevitably be some fees to pay during the life of your accounts. When you do business with a bank, you may be subject to any of the following, depending on the bank:
- Account maintenance fees
- Overdraft fees
- Early withdrawal fees
- Inactivity fees
- ATM fees
- Late loan payment penalties
- Lost card fees
- Check printing fees
- Credit card swipe fees
- Wealth management fees
- And more
Some of these fees, however, can be waived if you meet certain standards based on the bank’s policies. For example, some banks stop charging account maintenance fees when you enroll in direct deposit or if you keep a minimum balance in your checking account.
Net Interest Margin
Have you ever wondered where banks get the money they use to loan out to customers like you? When you deposit your money in a bank’s account, you’ve granted them permission to use your money for loan-making purposes. Net interest margin is the difference between how much the bank earns through lending customer funds and the interest they pay them back based on their account balances.
In other words, banks can loan out your money to others in the form of credit cards, mortgages, auto loans, and more. They usually charge high interest rates on these loans, which is how they then turn a profit on this money. A small percentage of this interest collected is put into your account as the bank’s way of rewarding you for helping them invest. Customers can be confident in the knowledge that banks (especially FDIC-insured banks) are limited in the risks they can take with customers’ money, even though the rules they’re held to are subject to change.
Even though your money is on loan most of the time, you still have full access to the entire amount because the bank is required to keep a minimum amount on hand at all times. The amount is determined by the Federal Reserve and is referred to as the “reserve requirement.”
Every time you use your credit card or debit card at a store, the merchant pays an interchange fee to the bank that issued the card in order to account for the risk of approving the payment, including fraud, handling costs, and bad debt. With credit cards, interchange averages about 1.81% of the purchase while it’s only around 0.3% for debit cards. Interchange is the reason that banks are able to provide rewards on their credit cards, as merchants must pay a higher fee when a user pays for purchases with a credit card under a reward program.
Learn More About Bank Profitability
Be wary that not every bank operates the same way. The methods used by financial institutions to make money may vary from location to location. So, before you open an account with any bank, make sure you understand their business model first. Do your due diligence and shop banks in your area, speaking to their representatives about any questions you may have along the way.