If you’ve ever taken out an installment loan, used a credit card, or paid bank account fees, you’ve helped keep a bank in business. Lending and account fees are both central to how banks make money.
Banks make money in other ways too, some of which could surprise you. Fortunately, the broad strokes actually aren’t that complicated for regular folks to understand.
How Do Banks Make Money?
Commercial banks provide deposit accounts and loans to consumers and businesses. They have two main sources of income: interest and fees.
This is in contrast to investment banks, which make money off business deals they help set up and from direct investments in companies (among other things). Investment banking can be extremely profitable. But it’s also extremely volatile — investment banks can lose tons of money in economic downturns — and not directly relevant to everyday folks’ lives. So we won’t focus on it here.
Main Sources of Commercial Bank Income
There are several different types of interest and fee income. Most commercial banks earn interest and fees from multiple sources, though the specific mix and share varies by institution and not all banks earn every type of interest and fee income.
Four types of interest and fee income are particularly common: interest on loans, interest on securities, interchange fees, and customer fees.
|Income Type||What It Is|
|Interest on Loans||Ongoing payments from borrowers to the bank, usually as a percentage of the loan amount or balance|
|Interest on Securities||Ongoing payments to the bank from external issuers of bonds and other financial products, such as U.S. Treasury bills|
|Interchange Fees||Fees paid to the bank by merchants when a bank customer uses their credit or debit card in a transaction|
|Customer Fees||Noninterest fees paid to the bank by customers, including account fees (such as monthly service charges) and loan fees (such as origination fees)|
Let’s see how banks benefit from each of these income sources.
Banks earn two types of interest: interest on money lent to customers and interest on securities held on their own accounts.
Which Type of Interest Is More Profitable?
The first type of interest — on money lent to customers — accounts for the majority of interest income for most banks. Banks typically buy low-risk securities with low interest rates, such as short-term U.S. Treasury bills, so they don’t get much of a return on these holdings. They charge higher interest rates on loans to customers. And because they try to lend out most of their cash, the total value of securities they hold is usually much lower than the total value of funds lent out.
Why Do Banks Charge Interest?
Banks charge interest on loans because lending money is inherently risky. There’s always a chance the borrower will disappear and the bank won’t recover the funds it lent out. Interest helps offset those unpaid, or defaulted, loans. It also helps fund the bank’s day-to-day operations — paying staff and rent and so on. Ideally, there’s some profit left over after all those expenses.
How Does Interest Work?
A portion of each loan payment goes toward the principal, which is the amount the bank lent in the first place. The remainder goes toward interest.
On an installment loan like a mortgage or car loan, the interest is front-loaded, so you pay a higher proportion of interest on earlier payments than on later ones. By the end of the loan term, you’re mostly paying principal. This progression is known as amortization, and it’s why you can save a lot of money by making extra principal payments on your mortgage.
But let’s keep things simple and see how interest works without any prepayments.
Say you take out a $300,000 mortgage loan. The term is 30 years and your interest rate is fixed at 6%.
To pay off your loan, you’ll make 360 monthly payments of $1,798.65 each. Your first payment is $1,500 interest and $298.65 principal. Your last payment, 30 years from now, is $8.95 interest and $1,789.70 principal.
Now for the punchline: Your total payments on the loan come to $647,514.57, of which $347,514.57 is interest. Your total interest payments exceed the loan’s value by more than $47,000.
So, yeah — banks make money on interest. Play around with this free mortgage calculator to see for yourself.
You didn’t know it, but your bank deducts a small fee from every credit or debit card transaction you make. This is known as an interchange fee, and it’s essentially the bank’s cut for participating in the exchange.
Card users don’t pay interchange fees out of pocket. Merchants do, indirectly, because your bank keeps their cut before passing along the rest of the payment. This is why some merchants don’t accept credit cards — it cuts into their profit.
Interchange fees don’t amount to much on an individual level, maybe 3% at most of each transaction. But think about how many purchases you make — and how much you spend in dollar terms — each month. Even on a relatively tight budget, say 15 purchases per month at an average of $50 each, your bank nets $22.50 (assuming a 3% interchange fee). Now multiply that by the number of customers who use the same bank and you can see why interchange fees are so important for banks’ bottom lines.
Banks can pass on a whole assortment of fees to their customers if they’re so inclined. Typically, these fees fall into one of two categories: account fees and loan fees.
Common account fees include:
- Account maintenance fees, sometimes called service fees
- Overdraft and nonsufficient funds fees
- Wire transfer fees
- Paper statement fees
- Replacement card fees
- Out-of-network ATM fees
- Account inactivity or early closure fees
- Early withdrawal penalties on certificates of deposit, though these are technically reduced interest payments rather than tacked-on fees
- Foreign transaction fees charged when the customer makes a purchase in an international currency
Common loan fees include:
- Origination fees
- Late payment fees
- Prepayment or early payoff fees
- Balance transfer fees on credit cards
- Cash advance fees on credit cards
Banks roll certain loan fees, such as origination fees, into the loan’s balance. Alternatively, they may deduct fees from the amount the borrower actually receives. In either case, this saves the borrower the out-of-pocket expense but either increases their effective interest rate (when the fee is deducted) or increases the total amount they owe (when the fee is added).
The difference can be substantial for the borrower and profitable for the bank. On a $50,000 personal loan, a 5% origination fee amounts to $2,500. If you deduct that fee from the loan proceeds, you receive only $47,500 but pay interest on the full $50,000. Over a 5-year term, that adds about $700 in interest to your final loan cost, which jumps from $13,054.08 to $13,741.13.
Banking Business FAQs
Banking economics is easy enough to understand at a high level, but the details do grow more complicated and confusing as you zoom in. Without getting too deep into the weeds, let’s answer some common questions about how banks make, manage, and protect their money.
What Do Banks Do With Their Money?
Banks lend out most of the money that flows through their coffers. They can’t lend out all their money because then they’d have nothing left for customers who want to withdraw funds, but they typically keep only a small percentage of total deposits in reserve.
Depending on the bank, they might offer:
- Mortgage loans
- Home equity loans and lines of credit
- Car loans
- Credit cards
- Personal loans
- Various business loans and credit lines, including business credit cards
Each type of loan or credit line has its own unique structure, with different interest rates and repayment terms. But all are designed to earn the bank more money than it lent out.
What Are Bank Reserve Requirements?
A bank’s reserve requirement is the amount of cash it’s legally required to keep on hand to fund withdrawals. State and federal banking regulators set reserve requirements, and they can adjust them based on economic conditions and other perceived risks.
There are two main types of bank reserves: primary reserves and secondary reserves.
Primary reserves are cash held in the bank’s vaults (or in its electronic accounts) and/or with its local Federal Reserve Bank branch. A bank with 20% primary reserves aims to keep 20% of its deposits on hand or with the local Fed branch and lend out the remaining 80%.
Secondary reserves are short-term securities that the bank can sell quickly to raise cash if needed. These are usually U.S. Treasury bills with short maturities (a few months to a year at most). Secondary reserves aren’t quite as good as cash held in a vault, but they’re very low-risk as investments go.
What Is the Multiplier Effect in Banking?
The multiplier effect describes how money lent by banks can grow as it moves through the financial system.
Let’s say you borrow $10,000 from Bank A to buy a car.
Bank A sends that $10,000 to the car dealer, which promptly deposits the money in its checking account at Bank B.
Bank B is required to keep a portion of that $10,000 in reserve. Let’s say its reserve requirement is 10%, so it has to hold onto $1,000.
Bank B is free to lend out the remaining $9,000, and because it wants to make as much money as possible, it does. To keep things simple, let’s say it lends the entire $9,000 to your neighbor, who also needs to buy a car.
Bank B sends that $9,000 to your neighbor’s car dealer. The car dealer promptly deposits the money in its checking account at Bank C.
Bank C sets aside $900 (its 10% reserve) and lends out the remaining $8,100 to your other neighbor, who is jealous that both you and your first neighbor have shiny new cars. Bank C sends the money to your second neighbor’s car dealer, which — you get the picture, let’s stop there.
The end result here is that your initial $10,000 loan became $27,100 after Banks B and C did their thing. That’s 2.71 times what you borrowed — a multiplier of 2.71x.
What Is a Good Return on Assets for a Bank?
This all seems pretty simple, so you’d be forgiven for thinking the banking business is as easy as printing money. Rest assured, it’s not — and in fact, as a percentage of total assets, banks don’t make very much money.
A good, healthy return on assets for a bank is about 1%. So if a bank has $100 billion in assets, which would make it one of the top 50 largest banks in the U.S., it would make $1 billion in profit in a good year. Needless to say, that’s a lot of money, even if a 1% return seems like nothing to write home about.
How Do Banks Make Most of Their Money?
It depends on the bank, but in general, commercial banks make most of their money on loan interest and fees. Banks often roll upfront loan fees into loan balances, increasing the amount of interest they can earn over time.
Investment banks make the majority of their money through investing and consulting activities. These activities are more custom and more complicated than lending money to consumers and small businesses, and because they don’t directly affect regular folks’ everyday lives, we haven’t dwelt on them here.
Can Banks Lose Money?
Yes, banks can definitely lose money. It happens all the time.
Banks lose money on individual loans when the borrower is unable to repay the loan. This is known as default.
Banks can recover a small amount of what they lent on defaulted loans or credit lines by selling the account to a collection agency, but we’re talking a few pennies on the dollar.
To avoid losing tons of cash on defaults, banks are often willing to renegotiate (or “work out”) loans with struggling borrowers. This could still result in a loss, but not to the degree that an outright default does.
Borrowers with low credit scores are more likely to default on loans than borrowers with good credit scores. To offset this risk, banks ask borrowers with bad credit to pay higher interest on loans and credit cards.
Basic banking economics is straightforward. Commercial banks make money by charging more interest on loans than they pay on deposits, by taking a small cut of debit and credit card transactions, and through various fees on loans and deposit accounts. Sure, they have other sources of income, but if you only focus on those, you still have a good grasp of how banks stay in business.
The details are more complicated. For example, to consistently turn a profit, banks have to minimize defaults and keep their loan portfolios profitable. Which means they have to think very carefully about who they lend to, how much, and at what rates. Which takes a lot of expertise that doesn’t come cheap.
And since banking is so important to the broader economy, banks are highly regulated. There are many, many things banks would like to do that they can’t, at least not legally. Though a net positive for bank customers, this is a significant constraint on banks’ financial upside.
This is one of several reasons the number of banks in the U.S. has been declining since the 1980s. Existing banks continue to close or merge at a brisk pace while new banks (“de novo” banks) are few and far between. There’s money to be made in banking for sure — but I wouldn’t recommend trying to start a bank yourself.