With the recent Wells Fargo fraud making headlines everywhere, some may want to know where banks are actually making their money. The core of the banking business model is lending. Banks create money by deriving income from interest collected on a variety of lending instruments. Additionally, banks supplemented this income with fees associate with services offered to account holders. In this post we’ll look at the specifics behind bank revenues and how they tie to the customer.
When an individual opens and funds an account they’re making a customer deposit. These assets belong to savings accounts, money market accounts or checking accounts. A more popular account option is the Certificate of Deposit, or CD. This option provides a superior interest rate for the customer so long as they’re willing to leave the funds untouched for a specified period of time (e.g. 1-3 years). A longer duration will yield larger rates.
Any homeowner will tell you that banks make significant income from mortgage loans. Even with today’s historically low interest rates banks are poised to make hundreds of thousands in interest from even a modest home. Families and businesses alike use mortgages to finance real estate purchases.
These loans are frequently made with either a 15 or 30 year horizon. The seller of the property receives the full amount from the bank as the new owner gradually repays the total, plus interest, over time. Today the average US 30 year mortgage rate sits at just 3.50% representing a historic low.
Loans extended for personal use command far greater interest rates. These rates are stratified based on the credit score of the borrower. An individual with superior credit history can expect to pay a 10.94% interest rate while those with poor repayment history will shoulder rates ranging from 20 to 28% according to lending surveys.
Personal loans are a popular choice for those seeking debt consolidation on credit cards. Personal loans will continue to bolster bank revenues given TransUnion’s reporting that, “secured and unsecured loans will continue to see balance increases and stable delinquencies through 2016.”
Lines of Credit
Unlike a conventional loan which infuses a lump sum of cash in one installment a line of credit represents a pool of money from which the borrower can draw as needed. The fees paid are only on the amount borrowed, not the entire sum. Banks make money not only on the interest but also the fees charged.
These fees, in some cases, are charged for not using the line. This instrument is most useful for the customer who doesn’t know to what extent they’ll need funds from month to month. The flexibility offered by a line of credit allows the borrower to use only what’s needed without incurring the higher financing charge that comes with a single-payment loan.
When lending money, whether it be for a mortgage, a personal loan or a line of credit, the bank will needs assurances that the customer will be able to pay them back. Banks would be in big trouble if they lent out all kinds of money and people were unable to give it back (i.e the 2008 housing crises). In order to asses the likely hood of being paid back, the bank will look at a persons credit score. This is a three digit number between 200 and 850, that tells the bank if you are financially responsible. If the number Is high (720 and above), the likelihood of the person being able to pay the bank back is high, allowing them to receive a lower interest payment (around 5%) on their loan. If the number is low (620 and lower), the person will probably not get a loan or they will get one with a crazy high interest rate (up to 20%).
Banks are adept at creating fees for nearly any service. In some instances simple check writing privileges result in fees. Considering refinancing your home at a lower mortgage rate? Expect to pay several thousands of dollars just for the processing of the paperwork alone. Overdraft charges also represent a significant source of income for banks. As seen in recently headline some fees are not even warranted or even legal. The list is long; there are account closure fees, maintenance fees and even paper statement fees.
Banks must maintain a minimum amount of cash on hand. This minimum is a portion of the total assets deposited by the account holders. To maintain this minimum banks frequently lend money amongst themselves. These are, in essence, short-term loans lasting less than one week. Banks create money when they lend to one another even for these short durations. These loans, like any other, have interest rates which are derived from the Federal Funds Rate, LIBOR and the Euribor.
Currency trading is a form of arbitrage where banks seek to profit from price discrepancies in exchange rates. When banks perform this service for customers they charge fees that often represent a percentage of the total transfer value. Transactions fees also apply. By adding to the spread in two prices banks create money and can profit from international currency exchange.