Like any business, banks sell something—a product, a service, or both. Banks work by selling money as a storage service. Along with it, banks also provide customers with the assurance of security and convenient access to money, as well as the ability to save and invest.
There are three main ways banks make money:
- Net interest margin
Net interest margin
When you deposit money into your bank account, you’re giving your bank permission to use your money to make loans. Your bank loans your money out to others at a cost to the lendee, in the form of an interest rate (think: mortgages, student loans, car loans, credit cards, etc.). Banks collect money off the interest paid by borrowers, and a small amount of that interest is given back to customers’ bank account. This is partially due to customers’ expectation that they will see a return when they “invest” their savings with a bank, as well as the bank’s way of saying thank you for the investment. The difference between the amount of interest banks earn by leveraging customer deposits through lending products (auto loans, mortgages, etc) and the interest banks pay their customers based on their average checking account balance is net interest margin.
Even though your money is being loaned out to other people, you can withdraw all of your money out of our bank account right now without a problem. This is because banks are required to keep a minimum fraction of customer deposits on hand at the bank, known as the reserve requirement. In the U.S., the reserve requirement is set by the Federal Reserve.
Interchange is the money banks make from processing credit and debit transactions. Each time you swipe your card at a store, the store, or merchant, pays an interchange fee. The majority of money from interchange goes to your bank–the consumer’s bank–and a little goes to the merchant’s bank. Because merchants have no control over interchange fees, there’s been some recent legislation that’s capped interchange fees on debit cards.
Ever wonder how banks can afford to offer incentives and rewards for using their credit cards? Interchange! Merchants are assessed a higher interchange fee when reward program credit cards are used to make purchases. Additionally, banks cover the cost by charging membership fees.
Fees are a relatively modern banking phenomena. In 1996, the Supreme Court ruled on the landmark case, Smiley v. Citibank, which included credit card late fees and other penalties under the definition of “interest.” Following this ruling, late fees spiked.
In 2007, two Acts were proposed to change the way that banks charge fees, but unfortunately, neither made it past Congress. However, in 2010, a federal law was passed that that requires that consumers must agree to debit card overdraft coverage with their banks before fees are charged or services are provided.
While late fees, overdraft fees, and ATM fees are relatively well known, there’s also a host of other fees that banks may charge customers.
Learn more about the ins and outs of personal finance.
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