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What Is Neobanking and How Does It Work?

By Timothy Moore · October 27, 2022 · 6 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is Neobanking and How Does It Work?

Neobanks are online-only financial technology (“fintech”) companies that offer traditional banking services in a digital-first format. Though they are called neobanks, these fintechs are not banks at all. Instead, they offer bank-like financial products, often designed for lower-income consumers and borrowers with a spotty credit history.

But how do neobanks work, and how do they make money? We’ll examine these and other topics — like the pros and cons of neobanks — below.

What Is a Neobank?

A neobank, also called a “challenger bank,” is a fintech that offers traditional banking services through a digital platform, usually online and via a mobile app. Neobanks typically do not operate physical locations or branches, meaning they’re a digital-only experience. This lack of physical branches means their overhead is lower — which may allow them to offer higher APYs on bank accounts and lower fees for consumers.

The big caveat with neobanks: They aren’t banks at all. Instead, they offer access to banking services and products that are overseen by true, federally regulated and insured banking institutions.

Recommended: Is Mobile Banking Safe?

How Do Neobanks Work?

Because of their digital-first strategy, neobanks are able to keep costs low and pass those savings on to consumers. Often, neobanks target their services at those who are frustrated with the traditional banking experience — those who may not qualify for a traditional credit card or loan or who have been burned by a mountain of fees on past checking accounts.

Tech-savvy users are often drawn to the advanced apps and platforms of neobanks in the same way they’ve been drawn to other digital disruptors, like Uber and Lyft in the rideshare space and Airbnb and VRBO in the lodging space.

Here’s an important distinction to note when thinking about what a neobank is: Just because a bank operates online doesn’t mean it’s a neobank. There are online-only banks that are fully regulated and directly offer FDIC insurance on deposit accounts. They provide an easy-to-use digital app and a full suite of banking services, and should not be considered neobanks.

But as we’ve pointed out, neobanks are not actually banks. So what does that mean?

•   While you can access traditional banking features like checking accounts, high-yield online savings accounts, and credit cards through a neobank’s mobile app, the neobank typically partners with larger traditional banks to offer those services.

•   Notably, neobanks do not typically offer a full suite of services, such as loans and investments, that full-fledged banks do.

•   Neobanks exist in a regulatory gray area. Many offer FDIC insurance through their partner banks, but the neobanks themselves do not answer to a primary regulator. The Consumer Financial Protection Bureau (CFPB), however, recently announced that it will enact stricter supervision of nonbank fintechs going forward. And in recent years, the CFPB and state regulators have investigated certain neobanks for isolated events.

   That said, a neobank must typically comply with its partner bank’s own standards and practices, dictated by federal and state regulation. Thus, indirectly, neobanks may face some regulation.

Pro Tip: While many neobanks offer consumers FDIC insurance through the banks with which they partner, it’s always a good idea to read the fine print before opening a deposit account to make sure it offers insurance. While bank failures are rare, that insurance can provide real peace of mind.

Recommended: Money Management and Setting Your Financial Goals

How Do Neobanks Make Money?

While each neobank is unique and likely to have its own varied revenue streams, these challenger banks commonly make money through merchant fees from card purchases. Such fees are also called “interchange fees.” Consumers don’t pay these fees; instead, businesses bear the burden.

As long as consumers regularly make transactions with their neobank debit or credit card, it can pay off big time for fintechs. Why? Smaller fintechs can charge merchants interchange fees seven times higher than larger banks that have more than $10 billion in assets.

Neobanks are relatively new, and many are still in the startup phase. As such, promising fintechs often receive millions of dollars in venture capitalist funding to get off the ground. Which players will be around for the long haul remains to be seen.

Recommended: How Are Financial Institutions Governed?

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Pros and Cons of Neobanks

Neobanks may make sense for some consumers, but they’re not for everybody. Before opening an account, it’s a good idea to weigh the pros and cons:

Pros

Cons

Lower fees Less regulated (not chartered with state or federal regulators)
Higher interest rates on deposit accounts May not offer FDIC insurance
May offer credit card without credit check May not offer a full suite of banking services (mortgages, auto loans, etc.)
Easy-to-use mobile app (mobile check deposit, peer-to-peer payments, etc.) Typically no brick-and-mortar branches
24/7 account access — and on the go Untested in the market (no long history of success to instill confidence in consumers)

Recommended: How to Keep Your Online Bank Account Safe

Examples of Neobanks

In the last decade-plus, the fintech market has been teeming with myriad newcomers. Here are six examples of popular neobanks, whose names you may recognize:

•   Varo Bank

•   Chime

•   GoBank

•   Aspiration

•   Current

•   Daylight

Recommended: How to Manage a Checking Account

Neobanks vs Traditional Banks

So how do neobanks compare to traditional banks? The table below breaks down common differences, but remember: Each bank (or neobank) is different and offers varying levels of services, rates, and fees. These are broad generalizations and may not apply to every financial institution.

Neobanks

Traditional banks

Fees May offer lower and fewer fees May charge higher and more fees
Interest on deposits May have higher interest rates on deposit accounts May have lower interest rates on deposit accounts
Offerings Typically offer checking and savings accounts; may offer a credit card Typically offer multiple checking vs. savings accounts and credit cards, as well as personal loans, home loans, auto loans, and mortgages; may offer investment and retirement accounts
Mobile app/online banking Typically have high-rated mobile app and online banking platforms May lag in app and online quality compared to neobanks (especially true for traditional, brick-and-mortar banks)
Physical location Typically do not have physical locations Typically have physical locations
Insurance May offer FDIC insurance through a larger bank Typically carry FDIC insurance (or NCUA insurance for credit unions)
Regulation May not be regulated Typically chartered and regulated

What About Online Banks?

The previous table does not capture all the nuances of online banks. The differences between online banking and neobanking were briefly noted above. However, it’s worth taking a closer look at how online banks compare to traditional brick-and-mortar ones. While they may offer the same breadth of products, online banks typically offer better rates and lower fees than traditional banks. Online banks also usually offer leading-edge mobile apps as well as FDIC insurance.

Online banks can afford to pay those higher interest rates and charge lower fees because, compared to traditional banks, they don’t have to pay for physical locations and on-premises staff. They can then pass some of those savings on to their customers.

Wondering if an online bank is right for you? Do your research on the pros and cons of online banking before making your decision.

Recommended: Online Banking vs. Traditional Banking

The Takeaway

Neobanks may be appealing to tech-savvy consumers who want high interest rates, low fees, and easy-to-use apps. Traditional banks, however, may offer more stability and confidence — and are formally regulated. The convenience of in-person banking and the full suite of banking services offered by traditional banks can also be appealing.

Online banks like SoFi can offer the best of both worlds. For example, when you open an online bank account with us, you have the security of knowing we’re FDIC-insured and the convenience of an easy-to-use mobile app, plus a Checking and Savings account that lets you spend and save in one place. What’s more, when you sign up with direct deposit, you’ll earn a hyper competitive APY, and pay no fees.

Better banking is here with up to 3.00% APY on SoFi Checking and Savings.

FAQ

What’s the difference between a traditional bank and a neobank?

Traditional banks usually offer in-person branches, are federally regulated, and offer FDIC insurance directly. They typically offer a full suite of banking services, including loans. Many neobanks are more narrowly limited to checking and savings accounts delivered digitally only, but they often offer more competitive interest rates and lower fees.

Are neobanks regulated like regular banks?

Neobanks do not face the same regulation as regular banks simply because they are not charted as banks with federal and state regulators. Instead, neobanks often partner with chartered banks. That said, the Consumer Financial Protection Bureau has announced that it will increasingly supervise and regulate the activity of neobanks.

Is your money FDIC-insured with a neobank?

Some neobanks offer their banking services through chartered financial institutions. Through those institutions, the neobanks may be able to offer FDIC insurance for their accounts and services, but some don’t. It’s therefore a good idea to read the fine print of a neobank before opening an account so you know where you stand.


Photo credit: iStock/Prostock-Studio

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2022 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
SoFi members with direct deposit can earn up to 3.00% annual percentage yield (APY) interest on Savings account balances (including Vaults) and up to 2.50% APY on Checking account balances. There is no minimum direct deposit amount required to qualify for these rates. Members without direct deposit will earn 1.20% APY on all account balances in Checking and Savings (including Vaults). Interest rates are variable and subject to change at any time. These rates are current as of 11/3/2022. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet
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