How Banks Make Money
Banks and other financial institutions play a big role in our lives, as they are often responsible for both holding our hard-earned savings and lending us money when we need it. But have you ever wondered how banks actually make money?
Here, we pull back the curtain to explain the different ways banks generate profits, from the interest earnings they get on loans to the fees they charge on deposit accounts.
What is a bank?
The first thing to understand about banks is they are businesses that exist to make money. Unlike credit unions, which are not-for-profit cooperatives owned by their members, banks are for-profit entities that offer financial services with the goal of turning a profit for their shareholders.
There are two types of banks: commercial banks and investment banks. Consumers are probably most familiar with commercial banks, which offer products and services including checking and savings accounts and loans for individuals and small businesses.
By comparison, investment banks primarily serve corporations and institutional investors, assisting with raising money through the sale of stocks and bonds and providing advice on mergers and acquisitions.
How do banks make money?
Banks generate revenue in several ways. Ultimately, a bank’s key path to profitability is to earn more in interest on the money it’s lending than the interest it’s paying on deposit accounts or to its own creditors.
Think of it like this: When you deposit money into an interest-bearing account, the bank pays you a small amount of interest. But it can recoup that money — and potentially earn more — by providing a loan to a borrower and receiving monthly payments on their debt.
Let’s say you deposit $1,000 into a savings account that earns the current average rate, which is 0.41%. This is a small amount for the bank to pay compared with what the same bank can earn through its lending activities. For example, average rates on auto loans are now about 6.61%, while rates on credit cards and personal loans are even higher.
The difference between the interest a bank pays and the interest a bank earns is known as its net interest rate spread. Banks also earn money through various fees for the services they provide. Let’s take a closer look at how banks make money through deposit accounts, lending activities and more.
How banks make money on deposit accounts
Many banks offer multiple types of bank accounts, including checking accounts, savings accounts, money market accounts, certificates of deposit (CDs) and more.
Although some of these accounts are interest-bearing, meaning the bank gives you interest on the funds you deposit, banks also earn money through various account fees. These fees might include:
- Monthly maintenance fees: These fees are charged for the privilege of having a specific account. Depending on the bank, monthly fees may apply to checking, savings and other types of accounts. Accounts with more advanced features typically come with higher monthly fees, though these fees may be waivable if customers maintain a minimum balance or set up qualifying direct deposits.
- Out-of-network ATM fees: If you use an ATM that doesn’t belong to your bank’s network, you might be charged a fee by both your bank and the ATM owner. These fees are typically charged per transaction, though you can find some banks with no ATM fees.
- Overdraft fees: If you spend more money than you have in your account, leading to a negative account balance, many banks will charge you a fee. Setting up overdraft protection — if your bank offers it — can help you avoid these charges.
- Nonsufficient funds (NSF) fees: Similar to overdraft fees, NSF fees may be charged if a scheduled payment is declined because of insufficient funds in your account.
- Early withdrawal fees: Some types of accounts, such as CDs, have set terms. If you make a withdrawal before the CD reaches maturity, you may have to pay an early withdrawal penalty.
Banks may also charge fees for providing paper statements, wire transfers, international transactions and for account inactivity. They can also make money from securities they hold, such as government bonds.
How banks make money on loans and credit cards
When you take out a loan, whether it’s a mortgage, a car loan or a personal loan, you agree to pay back the principal loan amount plus interest. This interest income is the primary way banks profit from their lending activities, but banks also generate revenue through various lending fees, including:
- Application fees: Some banks add a fee to cover the cost of processing a loan application.
- Origination fees: This is a one-time fee charged when a loan is processed and approved. Origination fees are commonly included on mortgages, auto loans and personal loans.
- Late payment fees: If you fail to make your loan payment on time, many banks will charge a fee.
Bank-provided credit cards function similarly. While credit card holders may be able to avoid interest charges by paying their balance in full each month, banks earn money on credit cards through:
- Interest charges: If you carry a balance from one month to the next, the bank will charge interest on the outstanding amount. Credit card interest rates are often high compared with loans.
- Annual fees: Some credit cards charge an annual fee for the benefits and rewards they offer.
- Transaction fees: When customers pay for products and services with a credit card, merchants pay a transaction fee to the bank or credit card company.
Other ways banks make money
Banks also charge for other financial products and services that diversify their revenue streams. Here are a few examples:
- Investment services: Many banks offer brokerage services, allowing clients to buy and sell stocks, bonds and other investments. They earn commissions on these transactions.
- Merchant services: Some banks provide services to small businesses that allow them to accept debit and credit card payments. For these services, banks charge merchants a fee — typically a percentage of each transaction.
- Financial advice and wealth management: Financial advisers provide guidance on investments, retirement planning, estate planning and more. Many banks charge fees for these advisory services.
- Trust services: Banks can act as trustees, managing assets on behalf of individuals, families or organizations, and they charge fees for these administrative services.
How do banks use their money?
Banks use their funds to fuel their core business: lending. Customer deposits can play a role in this as well. Banks can “buy” money from depositors, and they can lend out a portion of that money, essentially “selling” it to borrowers.
The profits they make also help banks grow their capital reserves, which are essential for covering potential losses and ensuring bank stability. This allows banks to continue lending to individuals, businesses and even local governments.
To put it simply, the money banks make is reinvested into their operations, allowing them to pay interest to depositors and continue issuing loans, which helps drive economic growth.
Frequently asked questions
How do banks make money on deposits?
Banks earn money from deposit accounts through various fees, such as maintenance, ATM and overdraft fees.
How do banks make money on loans?
Banks profit from loans by charging borrowers interest on the principal amount. They also collect fees associated with lending, including origination, application and late payment fees.
What do banks do with the money they make?
Banks can use their profits to pay dividends to shareholders and add to their capital reserves, which can provide a buffer against potential losses.
Through the lending process, banks also create money. When a bank issues a loan, it’s creating new credit that enters the economy as a deposit in the borrower’s account. This process is facilitated and regulated by central banks such as the Federal Reserve, which oversees the U.S. banking system and sets reserve requirements.