How Do Banks Make Money?
Table of Contents
Banks make money by charging for the services they provide as well as financial products. Among the ways they profit are by collecting interest on loans and assessing fees for banking services.
By learning more about this topic, you’ll be better able to choose the right financial institution for you and probably hold onto more of your cash.
Key Points
• Banks earn profits by charging borrowers higher interest rates on loans than they pay to depositors and by charging fees.
• Interchange fees from card transactions and various banking fees are significant sources of income.
• Online banks usually offer higher interest rates and lower fees than traditional banks.
• Credit unions, being nonprofit and member-owned, often provide better interest rates and lower fees than traditional banks.
• Regularly review your bank’s fee structure, opt for digital statements, and consider switching to an online bank to save money.
What Exactly Is a Bank?
In general, a bank is a financial institution licensed to receive deposits and make loans. Some banks also offer financial services, such as safe deposit boxes and currency exchange.
There are several different types of banks. Though they all generally provide similar services, each type has a few unique traits that can make it especially useful for certain types of customers and goals. Here are some of the most common options.
Retail Banks
Traditional banks that serve the general public, such as Wells Fargo, Bank of America, and Chase, are retail banks. Their focus is to help people manage their personal wealth.
Retail banks are generally easily accessible, often having hundreds of branches across the country and they provide the most basic of financial services for regular use.
Commercial or Corporate Banks
These banks specialize in providing financial support and assistance to small and large-scale businesses. Many also have retail divisions as well.
Where a standard retail bank might only be able to provide small personal loans, commercial banks often have the capacity to provide larger and more substantial loans, as well as other services, to help support new and expanding business ventures.
Online Banks
These are institutions that provide financial services just like any other bank, except they do not maintain any actual storefronts. To apply for an account with an online bank, such as Ally, SoFi, or Synchrony, applications must be submitted online and the entire banking experience is primarily conducted remotely via an internet browser or app.
Because online banks generally don’t have the expenses that come with maintaining a storefront, they can often offer higher interest rates and lower fees than many brick-and-mortar banks.
However, because they don’t have storefronts, you typically can’t make cash deposits.
Central Banks
In many countries, banks are regulated by the national government or central bank. In the U.S., the Federal Reserve System is the central bank of the U.S. It consists of 12 Federal Reserve banks that stretch across the country.
These central banks are responsible for implementing monetary policy, maintaining the stability of the financial system, controlling inflation, and providing financial services to banks and credit unions. The Federal Reserve banks are essentially banks for other banks, as well as the government.
Investment Banks
Morgan Stanley and Goldman Sachs are examples of investment banks. These banks specialize in managing some of the largest and most complex types of commercial transactions, such as merger and acquisition activity, initial public offerings, or financing large infrastructure projects like building bridges. Investment bankers often work on deals that involve raising capital and acquisitions.
How Do Banks Make Their Profits?
With the wide variety of financial products and services that banks offer, they create many opportunities for revenue. Those revenue streams generally fall into one of three categories:
Interest
One of the primary sources of income for banks and financial institutions comes from interest collected on the various loans that they offer.
Banks use the money from their clients’ checking and saving accounts to offer loan services. They then charge interest on these loans (based on the credit history of the borrower and the current federal funds rate). Banks then profit from the net interest margin. That’s the difference between the higher interest income charged for their loans and the lower interest paid out to clients on their bank accounts.
Recommended: Savings Account Interest Calculator
Interchange Fees
When people use their bank-issued credit and debit cards at a store, that store typically pays a processing fee, known as an interchange fee.
These fees are paid by the merchant’s bank to the consumer’s bank for processing a card payment. This fee is to help ensure security, payment, fraud protection and a speedy transfer of funds, and is typically a small flat fee plus a percentage of the total purchase.
Interchange fees help explain why some establishments maintain minimum purchase amounts for credit or debit card purchases.
Banking Fees
Banks typically bring in a significant amount of their money by charging customers fees to use their products and services. Banks may charge fees to create and maintain a bank account, as well as to execute a transaction. They may be recurring or one-time only charges.
All banks should be upfront about all of their fees and disclose them somewhere accessible to their customers. You can often find a bank’s fee schedule online or in the documents you received when you opened your savings and/or checking account.
It can be a good idea to learn about the types of fees that your bank charges in order to avoid or minimize fees and also catch any errors. If fees seem unreasonably high, you might also decide to switch to a different bank or financial institution that charges less.
Some of the more common bank fees include:
Service fee: A monthly fee charged for keeping an account open.
Account maintenance fee: A monthly fee charged for managing an account.
Withdrawal limit fee: Charged when a customer exceeds the maximum number of monthly withdrawals allowed on a savings account.
ATM fee: Charged when withdrawing funds from an ATM terminal outside of your bank’s network.
Card replacement fee: Charged when a lost or stolen debit or credit card is reissued.
Overdraft fee: Applied when a customer’s bank balance falls below zero. Interest can also accrue on the overdrawn amount, as the bank may see this as a short-term loan.
Non-sufficient funds (NSF) fee: Charged when a customer makes a transaction but doesn’t have enough money in their account to cover it. The transaction “returns” or “bounces,” and the bank charges the customer an NSF fee.
International transaction fee: Charged when making a debit card purchase in a foreign currency or withdrawing foreign currency from an ATM.
Cashier’s check fee: A fee for purchasing an official check from your bank.
Stop payment fee: Applied when requesting that a bank stop payment on a pre-written check from your account.
Wire transfer fee: Charged for electronically transferring funds from one bank to another.
Paper statement fee: A fee for providing monthly bank statements in the mail rather than digital statements online.
Credit Unions vs Banks
As for the difference between a credit union vs. a bank, a credit union is a nonprofit, member-owned financial institution. Like a bank, it can make loans and offer checking and savings accounts.
Members purchase shares in the credit union, and that money is pooled together to provide a credit union’s services. Individuals interested in banking with a credit union must fit specific eligibility requirements (sometimes regional, employment-related, or requiring direct relation to an existing member) and apply for membership.
Unlike a bank (which is a for-profit business), a credit union returns its profits to members, which means it may have lower fees and better interest rates on savings accounts and loans than traditional retail banks.
Because they are often smaller entities, however, credit unions tend to provide a limited range of services compared to banks. They may also have fewer locations and ATMs.
Recommended: Passive Income Ideas
The Takeaway
To make a profit and cover their operating expenses, banks typically charge for the services they provide. When a bank lends you money, for example, it charges interest on the loan. When you open a deposit account, such as a checking or savings account, there are typically fees for that as well.
It can be wise to take a second look at the fees outlined in your banking contract in order to get ahead of any surprise charges down the line. And to look for a fee-free bank if you are getting hit with these charges.
Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.
FAQ
How do banks make money?
Banks typically make money by charging interest and collecting fees.
What are three ways that banks make money?
Banks make money by lending money (loans) and charging interest; they charge fees for their services (such as overdraft coverage); and they invest customers’ money to grow it.
What is the main source of income for banks?
Typically, banks make most of their money on the interest margin involved in their business. Specifically, they earn money from the higher interest rate they charge for lending money vs. the lower interest rate they pay to holders of interest bearing accounts.
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