How Do Banks Work and How Do They Earn?

Have you ever wondered how do banks work and how they earn to sustain themselves?

 

If we’re guessing what you might have in mind, you’re probably thinking that all banks do is printing money. As cool as that sounds, it’s really not the case! So then, why are banks important, and how is it possible that banks manage to grow into one of the most lucrative financial businesses globally? That’s the topic we’re going to discuss in this article today. Again, as always, before we dive in, we’ll start with the basics so that you can have a clearer picture of how it operates.

What Do Banks Do?

Banks have been playing a fundamental role in the economy and society for many years. Not only do they keep our money save, provide us loans when we need them, they even help us pay big-ticket purchases in advance! If banks stop to oversee these functions one day, the flow of money in the economy would be grinded to a halt.

 

At its most fundamental operation, banks act as a bridge that links savers and borrowers. What this means is that when customers deposit money into their savings accounts, banks can take the deposit sum and lend to other people in the form of what’s called a loan. Now there’s no need for us to panic as there’s really nothing to worry about. When loans are issued to the borrower, an interest rate is charged. If anyone is unfamiliar with what interest rates are, they’re a fee charged as a percentage of the loan amount. In laymen terms, we can take interest rates as a borrower’s fee – like a form of gratitude by paying extra for spending other people’s money in advance.

 

So what happens to the interest fee after it’s paid by the borrowers? Well, since the bank not only draw money from one person’s account, the interest fee collected will be distributed to the savings account from which the bank has taken the money from together with the initial sum the bank took to borrow. Do you see the money ecosystem clearer now?

How Do Banks Earn?

They earn through a profitability metric called Net Interest Margin. Remember the interest rates we’ve talked about earlier? So, what Net Interset Margin essentially does is it measures how much a bank earns in interest compared to the outgoing expenditures it pays consumers. For instance, the interest collected by the banks through loans (earnings) are often much greater than the interest paid to the account holder’s savings account (outgoing expenditures). The difference between the two is basically what new interest margin is (the bank’s profit).

 

Calculation example:

Let’s assume that you have an emergency fund of $8,000 in your savings account yielding 1.5% per annum. Your bank will use this money to fund someone else’s mortgage (at 15% interest per annum), student loan (at 18% interest per annum) and credit card (at 12% interest per annum).

 

While you may have collected $120 per annum on interest through your savings account, the bank has collected a couple hundred or thousand interest on loans – all thanks to your savings account. Now imagine if the bank could earn this much from your emergency fund alone, how much more it would earn in total with millions of other customers! No doubt, it’s indeed a lucrative business with high returns!

 

Of course, Net Interest Margin isn’t the only way banks get their profit. They also earn through fees and penalty charges. Which bring us to our next point below!

Other Ways Bank Earn

1. Account Fees

To name a few financial products that may require an account fee, they include your savings account, credit cards, loans, and even investment accounts. These fees are unavoidable as they’re needed for the bank to make sure they keep your money secure.

 

2. ATM Fees

ATM fees are charged by the bank when you withdraw over a certain limit. This happens too, when you withdraw money from another bank’s ATM. However, some banks absorb this fee on behalf of their customers. Hence, you might want to check with the bank before opening an account with them.

 

3. Penalty Charges

If you’ve taken a loan or own a credit card, it’s always best practive to pay your bills and loans on time and in full. Penalty charges only happens when you miss a payment.

 

4. Application Fees

Applications fees are technically process fees. For instance, when you apply for a mortgage loan, this fee is charged for the loan process.

 

5. Interchange Fees

Interchanged fees are usually charge when a merchant is using a payment portal issued by the bank. These devices are those where you tap your debit or credit card to make a payment. Hence, you can take interchange fees as a bank service fee.

We hope this article has brought you some insights on how a bank works. It’s safe to say that banks have you best interest when it comes to money management. The services banks provide lsuch as savings account can help you grow your hard-earned money overtime. On top of that services like loans, have helped many people achieve their dreams like owning a home or opening up a new business. To learn more about how banks work, we’ve created a video here that you can check out!

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