Personal Finance 101: How Does A Bank Work?

Personal Finance 101Recently, I received a lengthy email from a reader who had a ton of basic personal finance questions contained within. I thought it might be interesting to start an irregular “personal finance 101″ series to answer and explain some of her questions.

Many people see banks as being a place where you save your money or where you get a checking account or where you can get loans, but they often don’t understand the big picture of how a bank functions. Let’s walk through it in baby steps so that you can understand why a bank exists.

First of all, a bank is a business like any other business: it strives to make as much money as possible. They make money by simply moving money around; keep that in mind as we move through the services that a bank provides.

The first service that most people become familiar with in terms of a bank is a savings account. At first glance, a savings account is a situation in which you give a bank your money for a period of time, withdraw it whenever you like, and it earns a small amount of money for the time you leave it there. What actually happens, though, is that a savings account is actually a loan, except this time you’re the lender. It’s no different than any other loan, except it’s really flexible: you can lend as much as you want to the bank and get that loan paid back whenever you’d like. Because of this flexibility, though, the interest you make on this loan is pretty low.

A checking account, at most banks, is no different than a savings account: you’re lending the bank your money, but with a checking account, they pay your interest with services (dealing with the checks you write, etc.) instead of interest.

The other major aspect that people think of when they consider a bank is loans: they lend money to people for automobiles, cars, and other things.

So how does a bank make money? For starters, they take the money you loan them and earn a pretty strong return with it, then give you a part of that return in the form of interest. So, each dollar you put into your account with the bank makes them a little bit of money.

Let’s say, for example, that the bank has a savings account with a 1.5% rate of return, which is likely better than the bank in your neighborhood. They take the money from your account (and a lot of other savings accounts) and use all of that money to buy (for example) a treasury note, which is guaranteed by the federal government and returns about 5%.

Even better, let’s say that someone else comes into the bank and wants to borrow some money for a car. The bank offers to lend them the money for the car at 7% return, so they take that money from the accounts at the bank and give it to the borrower. Then, the borrower pays back that money plus the interest, of which they pass on 1.5% to you, keeping 5.5% for themselves.

So, hypothetically, let’s say a bank opens for business and two people open savings accounts at 1.5% with $10,000 each. Then, Judy comes in and wants to borrow $20,000 for a car loan for one year, so the bank uses the $20,000 the people have deposited. At the end of the year, Judy will pay back the $20,000 plus 7% ($1,400). Then, each of the savings account holders come in and clean out their accounts. Each one takes out $10,000 plus 1.5% ($150) for a total of $20,300. The bank thus keeps the remaining $1,100. If that happens, say, 100 times in a year (200 savings accounts, 100 car borrowers), the bank makes $110,000 a year. When you start figuring in long term things like home loans, and also when people buy things like certificates of deposit, it becomes clear that a bank can bring in a lot of money each year.

On top of that, banks today make a lot of money from fees. You get pinged when you use the wrong ATM, when you overdraft a check, and so on. Each of these activities only costs the bank a few cents to handle, but it costs you a few dollars (at least).

To summarize, a bank works by paying people small amounts to lend them money, then lending that money onto others for larger amounts. They manage that whole process, and then keep the difference between the large amount (interest on loans) and small amount (interest from a savings account).

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13 thoughts on “Personal Finance 101: How Does A Bank Work?

  1. david says:

    Beat me to it, I started a post on how banks work for next week. Oh well, I like yours better!

  2. Nathan says:

    While most of us only really care about the personal side of the issue, most people don’t even think about how much banks make by providing services to businesses and corporations. Personal banking looks extremely simple when you consider checking, savings, credit. There are relatively few options along with that. In business banking, the amount of services, upwards of 25-30 “basic” services that have a seemingly infinite number of customizable setups. Being that the dollar amounts are so high and a demand is so strong, everything from fraud protection, overnight investing, electronic initiations, just to name a few, clients are very willing to pay large sums for all of these services.

    Just another aspect most people don’t think about, but in reality personal banking is second tier for most banks when thinking about revenue.

  3. James says:

    I can’t help but mention the 3-6-3 Principle. Borrow people’s money and give them 3%, lend their money out and get 6%, be on the golf course by 3pm. Sheer genius.

  4. terrell says:

    Hi Trent, I linked to your What’s in Your Wallet post on my company blog. Good information that I think our members will be interested in.

    Anyway, just wanted to say Hi and to say that I’d be interested in reading your thoughts on credit unions versus banks, if you have any. If you’ve already touched on that topic, could you direct me to that post?

    Keep up the good work!

  5. Trent says:

    Terrell: the line between bank and credit union gets blurrier by the day, but traditionally, a credit union was basically intended to be a nonprofit simple bank.

  6. Hey, great post!

    I hate bank fees, btw… I learned that the hard way. I made more than 6 transfers out of my savings account and was dinged $15! I called my bank up and they would not waive that fee.

  7. Debra Memmen says:

    Hi A long time ago my mom,gave her money after her house sold to a popazie scaam,because she thought that the bank wouldnt give her a high enough return on the large investement,only if she would of talk to a bank officer,shes still not over that so I’m so glad I can liearn about money Iam a working cowgirl,and this is not the business for the rich yet!! I have a plan.thank Debra

  8. Rev Jhunt says:

    If only people would take information like this serious enough to change their behavior and conduct towards money, banks, and other large glambing institutes and BECOME their own investment. We would have fewer poverty levels and more wealthy investors. Banks should only be used for thier least service and nothing more.

  9. Aaron says:

    Seems like it would be correct, but it’s not. The bank does not take money that is “lent” to it, and lend it out to the borrower. The bank simply writes money into the account. This money that is written into the account is not taken from anywhere, but the promise of the borrower to repay it. The bank then charges interest on the money they’ve created, and that is where the bank gets it’s money from.

  10. tom chi says:

    great stuff. please let me know when you explain where the money comes from that the Fed loans and who earns the interest on that money when they loan it to banks.

    thanks,
    tc

  11. Mister Mighty says:

    The article is ridiculous…absolute crap. So… for every mortage of $200,000 the bank needs $200,000 on deposit there? Preposterous! That’s impossible!!!

    Banks enter the amount of the mortgage into the computer. This increases the supply of “money” in the world. NOT CASH….”money”…which is a balance in a computer somewhere. (as opposed to CASH which is dollars and coin).

    BANKS MAKE THEIR OWN MONEY. FOR EVERY $10,000 THEY LEND THEY MUST HAVE $26.52 on deposit at the Country’s main bank. (Canadian Federal Bank, US Federal Bank).

    That $200,000 mortgage that you pay $1000 on interest every month cost the bank about $520 bucks to back…

    we are all slaves to the banks and don’t even know it.

  12. ShaunieBoi says:

    LOL i love some of these comments, but agree that a bank does not need $200k in deposits to lend $200k as a mortgage. It is all based on ratios. It also works differently around the world.

    Here in the UK, the banks have to ‘borrow’ the money to lend to customers as loans or mortgages via inter-bank loans from other banks, via the international ‘wholesale’ money markets or from the uk’s central bank, The Bank of England. All of these have a standard rate. The Bank of England uses Base Rate, for which banks then charge customers a certain percentage over this which provides its income. The other rate is LIBOR rate, and again the same principle applies. The Bank of England, being the central bank and similar in a way to the Fed, effectively has a near-limitless supply of monetary reserves, therefore creates this money against these.

    However we have a ratio which means that, in principle, to be able to lend £1 a bank will need to have £8 in ‘liquid assets’ to do so. The recent credit crisis (in the UK) apart from the knock-on effects of the US subprime lending, has occurred because banks have manipulated balance sheets as to what actually constitutes an asset, as accounting rules differ worldwide and banks are now all multi-national businesses.

    Anyway, thats my bit lol.

  13. Dennyyoung says:

    this information was very helpful because i planned on going to td bank later on in the week, actually tomorrow and i just wanted to further understand the ways of banking and things before i go and as a teenager mess up somewhere and become ruined!! Thanks Alot

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