How Do Banks Make Money?

Banks seem like a relatively simple concept. You give the bank your money to hold, and they promise to hold it for you securely. They even pay you interest depending on the length of time that your money stays in the bank. Then, when you need it, you withdraw the money in a variety of ways and go on your merry way to spend it. Banks have to make money somehow, though, in order to turn a profit, and the answer to their profits lies in loans.

While other business may sell tangible items, banks, in essence, sell money. Banks do that in the form of loans, certificates of deposit and other such financial products. Although it is awkward to say that banks "sell money," that is what they are doing, since the amount of interest that they charge on loans amounts to more interest than they offer for depositing money.

Therefore, if someone takes out a loan and eventually pays it back, the bank makes money off of the interest. The interest rates that banks charge depend on several factors. If people are not willing to take out loans and a trend appears, then banks will lower interest rates in an effort to get people to take out loans. It also depends on the amount of money that banks have to lend.

The Federal Reserve Board mandates that all banks need to have a certain amount of money left in reserve that they cannot lend out or spend otherwise. This is called the reserve requirement. Sometimes, banks borrow from each other to fulfill the reserve requirement at an interest rate called the funds rate, and this can sometimes affect the interest rate for private borrowers.

Interest rates can also be affected by how risky the particular loan is at the time. If a bank lends out several hundreds of thousands of dollars, it wants to make sure that it makes the money back as well as the interest. No matter the situation, banks make their profit based on whatever interest they receive from loans. Their costs, among those that all businesses have, include paying interest on deposits, but because of the higher interest rates on loans, they turn a profit anyway.

It may be difficult to envision a bank making money, but interest rates make the concept easier to fathom. Loans are specifically offered for the bank to make money, and certain things in life, like buying a house, usually require people to take loans out from the bank. In that regard, assuming that one can make the payments on the loan, it is a win-win situation for bank and consumer.

Resources

• Get information about the nation's largest banks.