How The Heck Does A Bank Make Money?
Especially if you're a hardcore saver, you may wonder exactly how a bank can make money providing the services they do. Let's look at four of the most common ways a bank can make a buck.
Lending Against Borrowers' Deposits
When a borrower deposits money in a banking account, the bank is allowed to use that money to make loans to others. You may wonder how that can work if they have to loan a dollar and can only back it with a dollar.
The simplest answer is that it doesn't work that way. Banks are allowed to leverage their deposits to make loans. If a bank has $10 of deposits, as an extremely simplified answer, it might choose to leverage that at a 10x rate. That means the bank could make $100 worth of loans against the original $10.
A bank also generally gets more back on loans than it pays out in interest on deposits. Your institution might only offer 0.55% interest on a savings account, but it might be taking in 6.5% on mortgages.
Penalties are also attached to many account services. If a loan payment is made late, for example, a fee might be charged. Early withdrawal fees on certificates of deposit are also common.
Most banks offer a range of services, mostly ones that aren't FDIC-insured. For example, most banks have highly secured vaults to protect their deposits. Boxes in these vaults are also rented to folks who want to protect valuables. If you wanted to keep your grandma's wedding ring safe, for example, you might put it in a safe box at the bank.
Regarding Depositor Protections
You might rightly wonder how your deposits are protected if the bank can be so highly leveraged. Two things protect your deposits.
First, there is what's called a reserve requirement. This is the amount of deposited money the bank is required by law to hold back in case depositors want to make withdrawals. In times of extreme financial crisis, the U.S. government has set this as high as 20% for some banks.
Second, most types of bank accounts are federally insured. Each depositor at a single institution is insured up to $250,000 by the Federal Deposit Insurance Corporation. Since the inception of the FDIC, a depositor has never lost any of the FDIC-insured funds they had. Interestingly enough, this insurance kicks in even if the bank gets robbed or burns down.