How Do Banks Create Money by Making Loans?
Banks borrow money from customers by offering them interest in return for depositing funds in certificates of deposit and savings accounts. The deposited money is lent to borrowers at a much higher interest rate than the banks pay to savings account and CD customers. The difference between the price the bank pays to borrow, and the price the bank pays to lend, is the profit margin and it enables them to make money by making loans.
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History
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Banks, financial institutions and private individuals have been lending for thousands of years. During the Middle Ages, the Knights Templar established the first major lending system that involved charging up-front fees and interest to borrowers. In the United States, the federal government encouraged banks to lend in 1934 when it established the Federal Housing Administration. The FHA insures mortgages that lead to banks raising loan-to-value limits from 50 percent in the 1930's to 100 percent at the end of the 20th century.
Types
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Banks provide consumers with a variety of lending options. Unsecured loans generate the most profit because they have the highest rates but lack of collateral makes them risky to banks. Home loans such as mortgages and home equity lines enable people to purchase or refinance property. Vehicle loans and mobile home loans usually have higher rates than home loans but much lower rates than unsecured loans. Banks also offer commercial building, equipment and unsecured loans.
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Time Frame
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Standard mortgage and home equity terms are for 15 or 30 years. Vehicle loans terms usually range from between 2 and 6 years and most banks limit lending to vehicles less than 10 years old. Commercial loans usually last between 5 and 20 years, but many banks require businesses to re-qualify each year. Small Business Administration government backed loans range between 7 and 25 years. Unsecured loans and revolving lines of credit have annually renewable terms or are open-ended.
Function
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Banks need to make loans to generate profits and pay employees, shareholders and cover operating costs. Loans held by banks create recurring income but banks also make short-term profits by selling mortgages to government sponsored Fannie Mae and Freddi Mac or other banks. Loans with high interest rates are attractive to investors and sell for high prices. Banks create further profits and reduce risks by selling loans to investment companies who bundle them together with other banks loans and then sell bonds with interest payments derived from the bundled loans.
Misconceptions
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Banks do not only use deposited funds to create loans. Banks borrow money from each other at prices based on the Federal Reserve Discount Rate. When the Federal Reserve keep the rate low, it becomes less expensive for banks to borrow institutional funds. Low inter-bank interest rates allow banks to increase profit margins and make more loans.
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References
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