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How Do Banks Make Money? Interest, Fees, & More Explained

Last Updated: January 12, 2023 No Comments – 2 min. read

Some people believe banks simply act as a vault for your savings, but they do a bit more than that. Here we'll look at how banks make money.

Disclosure:  Some of the links on this page are referral links. At no additional cost to you, if you choose to make a purchase or sign up for a service after clicking through those links, I may receive a small commission. This allows me to continue producing high-quality content on this site and pays for the occasional cup of coffee. I have first-hand experience with every product or service I recommend, and I recommend them because I genuinely believe they are useful, not because of the commission I may get. Read more here.

Contents

  • Interest on Loans
  • Fees
  • Investment Income

Interest on Loans

The word “bank” typically refers to institutions that accept deposits and make loans. One of the primary ways banks make money is from loan interest. When a depositor puts money in a savings account at a bank, they likely receive a small interest rate from the bank on that amount. The depositor expects to be able to get their money back anytime in the future.

Because the depositor doesn't need their money at the moment, the bank is able to borrow some of that money at that rate and lend it out to borrowers at a higher rate. The rate differential, called the spread, is the bank's profit. This process of providing credit is called financial intermediation, and it's the cornerstone of most financial systems.

For example, suppose the bank pays you a 1% interest rate and gives a loan to a borrower at 3%. The bank thus earns 2% in profit. Examples of such loans are auto loans, mortgages, business loans, and personal loans. These loans will typically have an interest rate much higher than that which the depositor is earning on their savings account.

The bank is able to loan out your money due to what's called fractional reserve banking – banks are only required to keep a small percentage of your actual deposits in reserve. Fractional reserve banking is a fundamental part of modern economies.

For example, if you deposit $100 in your account, the bank may only be required to actually hold 10% or $10 in reserve and can lend out the other 90%. Primary reserves are actual cash. Secondary reserves are short-term securities like government bonds.

Fees

An obvious way both commercial and investment banks make money is from fees. These fees can take many forms and can be recurring or one-time. These could be things like:

  • Account maintenance fees
  • ATM fees
  • Wealth management fees
  • Loan servicing fees
  • Overdraft charges
  • Interchange fees
  • Wire transfer fees
  • Corporate transaction advising fees
  • etc.

While this revenue source may sound insignificant at first glance, these fees can add up over time across many accounts. For example, according to the Consumer Financial Protection Bureau, so-called “free” checking accounts generate about $8 billion in annual revenue for banks from overdraft fees alone.

Fees are an attractive revenue source for commercial banks because they are more stable and predictable than others that fluctuate with interest rates and economic conditions.

Investment Income

A bank may choose to invest some of its reserves in assets like stocks, bonds, and real estate just like individuals do, earning them a positive return on that money over time.

For example, a bank can buy a government bond that pays periodic interest payments until maturity, a portfolio of dividend stocks that pays regular cash dividends, or property that is expected to appreciate in value that can be sold later for a capital gain.


Disclaimer:  While I love diving into investing-related data and playing around with backtests, this is not financial advice, investing advice, or tax advice. The information on this website is for informational, educational, and entertainment purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a research report. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. I always attempt to ensure the accuracy of information presented but that accuracy cannot be guaranteed. Do your own due diligence. I mention M1 Finance a lot around here. M1 does not provide investment advice, and this is not an offer or solicitation of an offer, or advice to buy or sell any security, and you are encouraged to consult your personal investment, legal, and tax advisors. Hypothetical examples used, such as historical backtests, do not reflect any specific investments, are for illustrative purposes only, and should not be considered an offer to buy or sell any products. All investing involves risk, including the risk of losing the money you invest. Past performance does not guarantee future results. Opinions are my own and do not represent those of other parties mentioned. Read my lengthier disclaimer here.

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About John Williamson, APMA®

Analytical data nerd, investing enthusiast, fintech consultant, Boglehead, and Oxford comma advocate. I'm not a big fan of social media, but you can find me on LinkedIn and Reddit.

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