How Do Banks Make Money?
The chances are, you have some sort of bank account. It could be a checking account, savings account, or some other account that banks offer. In fact, almost 94% of American’s have some sort of affiliation with a bank. Banks are an important piece of the broader financial system. They offer a way from people to store their cash safely and securely. They also loan money to people and businesses in need of cash. So how do they make money? In this post, we’ll explain the main ways banks make money and what you can do to keep more money in your bank account and less in theirs.
Top Ways Banks Make Money
As mentioned above, banks make money through a wide assortment of products. Mortgages, personal loans, business loans, and banking fees are some of the most common ways banks make their money.
Banks thrive off of mortgages. Each time someone chooses to finances a property, banks can make tremendous profits. So how does this happen?
Whenever you take out a mortgage, you will have to pay for the purchase price of the home plus interest charged by the bank. For example, if you purchase a home for $200,000 with a 5% interest rate over 30 years you will end up paying a total of $386,512, $186,512 of which is mortgage interest. That’s quite a bit of money for just one property! Mortgage rates are determined by many factors including the individual's credit score, market conditions, and the length of the loan.
If you need cash fast, banks will offer personal loans so that you can have it when you need it. These loans are typically structured with simple interest meaning you will pay a certain amount each month plus the interest accumulated. Personal loan interest rates are determined similarly to mortgages with your credit score being the largest factor followed by the amount of the loan, the length of the loan, and market conditions. You can expect to pay anywhere from 5% to 15% APR for your personal loan.
Just as people might need money, so do businesses. And banks will happily lend them money profiting on the interest paid. Business loans will typically have lower interest rates than personal loans but come with several caveats. For most business loans, your funds can only be used for business expenses, some loans will even come with restrictions on what the funds can and cannot be used for. In addition, getting approved for a business loan might be somewhat more difficult for new businesses as banks will look for a history of sound finances. If you cannot get approved for a business loan, you can always consider a personal loan as they will not have any restrictions on how you plan to use the funds.
American’s spent $34 billion in overdraft fees alone in 2017. Fees are the easiest ways for banks to make money. Between overdraft fees, account maintenance fees, ATM fees, lost card fees, returned check fees, and more it’s easy to see how they can rack up the cash. Banks can charge fees for virtually anything, so it’s a good idea to always go over any potential fees when opening an account. Some of the most common fees are:
- Account maintenance fees
- Overdraft fees
- Returned check fees
- ATM fees
- Lost card fees
- Foreign transaction fees
- Minimum balance charges
Whenever you swipe your card at the cash register, the business doing the sale is forced to pay a fee. This fee is collected by the bank or credit card being used. Typically it is around 2-3% of the transaction which can provide the bank an endless stream of income. While this fee may not be explicitly passed on to the customer, it could be in other ways.
Why We Need Banks
Like we’ve mentioned, banks are an important part of the global economy. If banks were nonexistent, it would make it nearly impossible for potential homeowners to purchase a home and it would make it difficult for small businesses to grow. Banks also provide us a safe and secure place to store our money, making them useful for many.
Borrowing Money Can Be Beneficial
One of the top reasons we need banks is to borrow money. The idea of borrowing money is not pleasant, but it can prove to be beneficial for many. By purchasing a home, you could view it as an investment. Once your home is paid off, it could be worth much more than you have paid for the home leaving you with a profit on the property.
The same goes for small businesses. By investing money into a business you could become extremely profitable making borrowing money a wise choice.
Safe & Secure Place to Store Money
One of the most well-known reasons for banks is to give us a safe place to keep our money where we do not have to actively worry about it getting lost or stolen. Banks are required to ensure your money up to $250,000 so that if it were to go missing, you wouldn’t be left in the dust. They are also required to keep a certain amount of your deposit in cash reserves so that you can withdraw it at any time.
How to Avoid Banking Fees & Interest
Avoiding banking fees and interest should be a part of your personal finances in order to keep more cash in your bank account and less in their quarterly revenues. These costs can quickly add up to hundreds of dollars per month or more so it should be a priority for your finances.
Decrease Mortgage Interest
One of the best ways to lower the amount you pay the bank is to decrease your mortgage interest. There are a few different ways of doing this that can save you thousands per year.
Go with a 15 Year Mortgage
By choosing a 15-year mortgage instead of a 30-year mortgage, you can typically shave 0.5% to 1% off of your interest rate. Using the same $200,000 house as above, your total cost of a 15-year mortgage would be $284,686. This is a savings of $101,826 over the life of the loan!
Refinance to a Better Mortgage Rate
Your second option for lowering mortgage interest is to refinance to a lower rate. It’s a good idea to check market prices to understand if you can expect a lower interest rate or not. If you’ve made payments consistently on time and your credit score has increased, you can expect to obtain a lower rate, therefore saving you money.
Pay Extra on Your Mortgage Balance
By decreasing the length of your loan, you will, in turn, decrease the amount of mortgage interest you pay. Even if it’s just an extra $25 a month, this can drastically lower the amount of interest you pay in the long haul. Some people will choose to pay their mortgage bi-weekly instead of monthly in order to make one additional payment per year. Just be sure that your additional payment goes towards the principal balance and not your next payment.
Choose a Bank with Low Fees
Luckily for consumers, banks have been shifting away from charging outrageous fees and are instead trying to attract long term customers where they can profit later. You can still expect to pay that overdraft fee, however. Newer banks like SoFi and Chime have offered no account maintenance or ATM fees.
Audit your current checking account to see if there might be better options to save you money. In addition to lowering fees, many banks now offer interest on checking accounts. SoFi currently offers 1.6% APR on your checking account which can add up to hundreds per year in income.
Be a Good Borrower
One of the best ways to lower the amount you pay in fees is to pay your accounts on time. Late payment fees can cost as much as $35 per late payment, not to mention the other drawbacks like a blow to your credit score.
In addition, you should also aim to pay off any loans early. Whether it’s a personal loan, business loan, or mortgage, by paying your loans off early you’ll save hundreds per year in interest alone.
Banks are a critical piece of the global economy and provide consumers with a safe place to store their hard-earned cash. They encourage economic growth by lending capital to those in need. Banks provide many potential first time homeowners the ability to purchase a home whereas it would otherwise be nearly impossible.
But banks are a business themselves. They exist to make money for their owners and or shareholders. They are able to charge interest and fees to customers in order to make a profit. By offering many different products, their income streams are diverse and extremely profitable.
There are many ways you can save on these costs. Minimizing the interest of your mortgage or any loans should be a top priority for your finances. It’s also wise to choose a bank that imposes little to no fees in order to keep your account padded. Some banks will even offer interest on checking accounts which can add up to hundreds per year in income.
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