Have you ever wondered how banks make money?
Banks are in the business of making money, that much isn’t a secret. But how do they do it?
And how can some banks offer much higher interest rates on savings and checking accounts than their competitors, or on the flip side, offer much lower interest rates for mortgages, auto loans, and other financial products and services?
This is actually a fairly detailed set of questions, and answering it will take 2 articles.
We’ll cover part one today – how banks make money, and part two tomorrow – how can banks make money by offering higher interest rates and better rewards programs?
The answers might surprise you!
How Do Banks Earn Money?
Savings, Deposits, and Loans
How can banks afford to pay interest on savings account deposits?
By lending out more money.
Banks are in the business of selling money, and mortgages, auto loans, HELOCs, credit cards, small business loans, and other loans can be a lucrative business. But banks need money on deposit to be able to lend money.
The Federal Reserve requires banks to keep a certain amount of cash, or a reserve balance, on deposit at their local Federal Reserve branch office at all times, which limits the amount of money banks are able to lend to customers.
How are savings account interest rates determined?
The basic answer is interest rates are based on the federal funds rate, which is set by the Federal Reserve.
The federal funds rate is the rate banks charge each other for overnight loans of federal funds. There are many other factors that may come into play, but this serves as the basis for setting interest rates.
In tomorrow’s article we will see how some banks are able to offer much higher interest rates than other banks.
Fees, Fees, and More Fees
I once belonged to a credit union that charged customers $1 to make a withdrawal or deposit if they didn’t have a pre-printed deposit or withdrawal slip.
I guess their computers could read the pre-printed codes, but a slip that was handwritten took 30 seconds longer to process.
The first time they tried to charge me a $1 fee I asked if the fee could be waived.
They said it couldn’t, so I canceled the transaction, closed my account and walked out with a couple grand in cash, which I promptly deposited in the bank across the street.
They changed their policy a few months later, but I never went back.
Fees are one of the biggest money makers banks have, and they fiercely guard their ability to make those charges (see some of the recent talk in Congress about limiting banking fees).
Other Common Bank Fees Include:
- Account and maintenance fees. Usually assessed on a monthly basis.
- Overdraft fees. A potentially nasty fee, usually in the mid $20 to $40 range per overdraft. Some banks assess debit card transactions from the highest to the lowest instead of by when the transaction cleared, causing more overdraft fees to be assessed.
- Bounced checks and insufficient funds fees. Most bounced check fees are similar to overdraft fees, and range from $20-$40.
- Late fees. This can be for mortgages, credit cards, or other loan payments. These fees can be assessed if they receive payment as much as a few minutes after the close of business.
- Minimum balance fees. Some banks charge a penalty if your balance drops below a certain limit. This can be a charge for the month, or result in a lower interest rate.
- ATM Fees. These range anywhere from $1 – $4. Here are tips to avoid ATM fees.
- Paper statement fees. Some banks now charge customers a fee to receive a paper statement instead of receiving an electronic copy (which is free). They simply pass the postage and processing fees on to the customer. (Note: Some banks only offer electronic statements).
- Loan application and closing fees. These can range from a few bucks for a small loan to several grand for a large mortgage.
- and a host of other fees.
Overdraft fees changing.
A recent law changes how overdraft fees can be assessed.
Read more about new overdraft fee laws.
Complimentary Services – Investing, Insurance, and More
Some banks charge higher investment fees than many companies that specialize in investing, which is why I believe it is usually better to open an IRA with a brokerage firm instead of a bank.
Some banks also offer insurance products, notary services, checkbooks, and other products.
Finally, we would be remiss not to add commissions.
Many banks have referral programs for products and services which helps them generate hundreds, or thousands of dollars on a local level, and hundreds of thousands or even millions on a national level.
What Does This Mean To The Average Consumer?
Well, first, it doesn’t mean banks are evil.
They are businesses and need to make money.
Trust me, you want banks to make money, otherwise our economy would be in for a major downturn.
Profitable banks also makes for more competition, and keeps interest rates competitive. (see a list of the highest interest rates).
On the flip side, you should be aware of the fees and how you can avoid most, if not all of them.
When joining a bank, be sure to read the small print to determine which fees you can avoid.
The average customer can avoid most, if not all, fees by signing up for free accounts and maintaining a minimum balance.
For the most part, consumers can still earn decent interest rates without paying many banking fees.