Saturday, December 11, 2010

How can a bank pay me interest for my Money and Still Make a Profit?

As someone who hopes someday to earn money, I look forward to depositing a modest sum every month into my bank “for some rainy day”. I will enjoy watching the money pile up (slowly) and the added benefit is that the bank actually gives me a modest “interest” for the money I deposit – currently around 1% to 2% depending upon the terms.

When I was young I always wondered “How do they just MAKE money??” and how can they afford to do that – I’m sure a LOT of people don't mind just letting their money sit there and grow !”. As it turns out, the bank not only ACCEPTS money from its depositors in exchange for interest, but it also LOANS money to some borrowers – at a considerably higher rate ! That is where the bank makes money, and that is where the bank is happy to pay you a small amount to keep your money.

A bank will loan money to individuals for many reasons – Auto Loans, Home Purchase Loans, Business Loans, etc. Each of these loans will have a rate associated with it, depending upon the amount, length, perceived risk, etc. Sometimes to reduce their risk and your rate, a bank will make a loan which is “secured” – an agreement that you will have to give up something of value if you fail to repay the loan with the terms you have agreed. Loans vary widely but can be 3% to much higher depending upon various factors.

Your previously proven ability to repay loans also is factored in when a bank determines what interest rate they will charge you as a borrower. If in the past you’ve managed your money very well, the bank will likely give you a better rate. This is where your “credit score” comes in. Your actual credit score is a number that is determined by the “credit ratings” bureaus. The three main credit ratings bureaus in the US are Experian, TransUnion, and Equifax.

It’s important to keep in mind that banks don’t keep all deposits available in cash. Typically, a bank will keep between 5% and 15% of their cash on hand for cash withdrawals. Banks have expert predictive models and software to help them determine the likelihood and amount of withdrawals at any given time.

Finally, banks do make money in other ways, including overdraft fees, checking fees, ATM fees, etc, and also in some cases issue credit cards, which can have very high interest rates !

To Summarize,

Depositors will deposit money and get 1% - 2% for their deposits

Borrowers take loans (secured + unsecured) and pay 3% and higher (depends)

Banks base their loan rate based on risk factors and credit ratings

Banks make money with other fees (ATM, Checking) and some issue Credit Cards.

It's a complicated process, but enough banks are doing this well that it's certainly a very proven system !

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