Banking 101: How do banks make money?

Odds are you hold at least some, if not all, of your money in a checking or savings account (or both).

Odds are you have at least one credit card (if you don’t, you should remedy that ASAP).

Odds are you have, or have had at one time, some type of loan — be it a student loan, an auto loan, a mortgage, or perhaps all of the above.

While you most certainly recognize these as products offered by banking institutions, you may not have known that none of them are free. Banks have to stay afloat somehow, and they do so in subtle ways like monthly maintenance fees on your checking account or interest on your auto loan.

Below, we’ll cover the ways banks earn money so they can continue to help you manage yours.

When you think of a bank, what comes to mind? Checking accounts? Credit cards? Loans? Banks provide a wide range of services, but the most prevalent (and the most relevant to me and you) fall under two categories: money held for customers and money loaned to customers.

Banks need to earn some sort of revenue from these services, and they do so in two primary ways.

Fees

Fees are the main way banks make money on the cash they hold for customers.

If your checking account has a monthly maintenance fee, for example, it’s part of that bank’s income. If you recently traveled overseas, you may have noticed a fee for using your credit card abroad. This is a foreign transaction fee, and it’s another means of money-making.

Here are some examples of bank fees, many of which you’ve probably paid:

• Monthly maintenance fees
• Credit card fees
• ATM fees
• Foreign transaction fees
• Overdraft fees
• Interchange fees
• Origination fees
• Late fees
• And so on…

Interest

Interest is how banks make money back on the cash they loan to individuals and businesses.

When you borrow money from your local bank to buy a new car, for example, the bank isn’t doing you a favor; they’re providing a service, and you have to pay for that service. The primary way you repay the bank for loaning you money is through interest.

Some of the products banks charge interest on include the following:

• Home loans
• Auto loans
• Personal loans
• Business loans
• Student loans
• Payday loans
• Credit card debt
• And so on…

Other bank income streams

While banks make a significant chunk of their income through various fees and interest, their revenue is truthfully much more diverse.

Banks also provide capital markets services, which essentially means they work with investors and businesses who need help with a range of financial activities. Some clients may need help funding a project. Others may need assistance with underwriting and/or building equity. Another business may require the support of an advisor or team of advisors through a merger or an acquisition.

Capital markets services are diverse, but they’re also inconsistent. This is why many banks lean more heavily on revenue from fees and interest.

In short, no.

While many banks bring in the bulk of their income through interest and fees, the weight they place on different income streams varies. This is because banks offer two types of services: commercial and investment.

Some banks focus on commercial banking. Some focus on investment banking. Others, but not all, offer products that fall under both categories, and those that do may make more money through one type of banking than another.

Knowing what your bank offers will help you understand why they charge the interest and fees they do.

Commercial banking

Commercial banking is likely more familiar to you, because commercial products are available for individuals and small to mid-sized businesses. In fact, when you hear the term “bank,” more often than not it’s in reference to a commercial bank. The products offered by a commercial bank include deposit accounts (checking and savings accounts) and loans (auto loans, home loans, etc.). Understanding how banks makes money provides insight into how they are able to offer incentives for signing up or meeting certain requirements.

Investment banking

Investment banking refers to products and services for the “big boys.” We’re talking corporations, high-net-worth individuals, and even governments. These institutions offer financial advice and wealth management, engage in trading activities, and more.

At a glance, it may seem like credit unions and banks are virtually the same, and in many ways they are. For instance, both charge customers interest and fees. One notable difference, however, is that credit unions are nonprofit businesses that are owned by their customers, while traditional commercial banks are owned by shareholders.

The reason this difference matters from a money-making standpoint is that credit unions are only making enough to cover their own expenses, while banks are actually trying to make a profit. Consequently, credit unions are typically able to offer lower fees and interest rates for their customers.

This said, one of the major drawbacks to working with a credit union is they’re generally smaller than commercial banks, which means they have fewer branches to work with and fewer products.

Now that you have a clearer idea of how banks make money, you’ll be able to identify opportunities to reduce those funds. Here are two simple suggestions to trim your banking costs:

Pay attention to bank fees

While every bank must charge some fees and interest to stay in business, there are plenty of “fee-free” services you can consider to cut costs.

For instance, online banks are able to maintain lower costs since they don’t have to pay for physical branches. As a result, they can reduce — and sometimes even eliminate — certain fees, like monthly maintenance fees.

Another easy fee to avoid is the overdraft fee; all you need to do is opt out of your bank’s overdraft protection and make sure you monitor your account balance to avoid spending more money than you have available.

Shop around before you buy

Banks may sell similar products, but they don’t all charge the same rates and fees.

As mentioned previously, for instance, online banks are able to offer customers reduced fees, because they don’t have to pay for physical branches. With this in mind, before you open a new credit card or take out a personal loan, make sure you spend some time shopping around and comparing options.

Believe it or not, your bank isn’t free.

Banks have to make money to stay in business, and they do so in a number of ways. If you have a checking account, you’re paying the bank in fees to store your cash. If you have a personal loan, you’re paying the bank in interest to borrow money. But not all banks have identical income streams and understanding how your bank makes money can help you learn how to trim costs for yourself.