Have you ever found yourself wondering, “how do banks make money?” Keep reading as I provide insights along with tips for ensuring banks don’t take you for a ride.
How do banks make money?
1. Service charges
Many banks charge account and transaction costs such as the following:
- monthly maintenance fees charged purely for having an account
- usage fees charged when your number of transactions exceeds a certain amount
- insufficient funds fees for attempting to process a transaction without enough money
- transfer fees for moving money around (i.e. wire or electronic funds transfers)
- ATM fees charged when you withdraw money from an ATM
- low account balance fees for not maintaining a certain threshold in your account
- debit card replacement fees charged whenever you lose or damage a card
- check delivery fees for when you need a new checkbook
- foreign exchange fees charged whenever you convert currencies
Revenue from these fees can be substantial. According to CNBC, U.S. banks generated more than $30 billion overdraft fees alone throughout 2020.
How to avoid bank service charges
Before opening a new bank account, do some research. Compare fees across account types and institutions to find an option that meets your needs at a competitive price.
You’ll likely find online-only banks charge the lowest fees (one caveat being that such institutions often have lackluster customer service).
A third tip would be to look out for promotions. Banks often waive fees if you sign up for multiple products, transact a certain amount monthly, set up a direct deposit, or jump through some other hoop.
2. Interest on loans
When you deposit money in a bank account, the associated institution lends some of it to people seeking loans (i.e. mortgages, lines of credit, etc). They charge those borrowers interest rates higher than what you receive for maintaining a balance. That’s the fractional reserve banking system in a nutshell.
How to avoid bank loan interest
There are two sides to this.
First, as a borrower, avoid paying interest unnecessarily. Even seemingly manageable amounts of interest add up. According to Self, the average American pays $130,462 in interest over the course of their lives. That’s a lot of money – for reference, Personal Capital pegs the median 401k balance for 65-year-old Americans at just $64,548.
You should also try to maximize your money’s potential by investing as much of it as possible. Personally, I don’t keep money in bank accounts beyond what I need to prepare for unexpected expenses and pay bills. I invest everything else in stocks, which keeps my money working for me rather than the bank.
3. Investment product and service fees
Many major banks in Canada and the United States offer investment products such as mutual funds and self-directed brokerages accounts.
While these products are designed to help you make money, they also come with substantial fees that enrich banks. For example, mutual funds charge between 0.5% and 1.5% annually, according to NerdWallet. Meanwhile, self-directed investment commissions range between $10 and $100 per trade, according to Investopedia.
How to avoid bank investment fees
Big banks no longer have a monopoly on investment products and services. There are many smaller discount brokerages and platforms that charge lower fees for access to the same assets. Acorns and Wealthsimple Trade are two examples I’ve written about.
Research your options thoroughly before choosing an investment platform. Lowering your investment fees by even a few fractions of a percentage point adds up over several decades.
4. Market speculation
In the United States, retail banks are allowed to purchase speculative assets using customer deposits. When those investments pay off, banks profit massively since the customers who actually own the underlying capital are only entitled to a small amount of interest, if anything at all.
Before 1999, the Glass-Steagall Act prevented any retail bank from earning more than 10% of its income this way. When the legislation was repealed, banks began taking greater risks with customer deposits. Many people argue this contributed to the 2008 financial crisis.
How to avoid getting fleeced by speculative banking
The Federal Deposit Insurance Corporation (FDIC) covers $250,000 per account type and depositor. If your bank speculates too aggressively and goes under as a result, the federal government will cut you a check for any amount lost up to the coverage limit.
Not sure whether your money is covered? Call your bank and inquire. Bank failures are exceptionally rare but it’s still good to stay on top of things.
It may also be wise to limit the amount of money you keep in checking and savings accounts. As I suggested earlier, investing your capital ensures you (not big banks) turn a profit.
5. Credit and debit card interchange fees
Whenever you make a credit or debit card purchase, your bank charges the merchant what’s known as an interchange fee. This fee’s size varies depending on the merchant’s industry and what type of card you have. If you have a rewards card, for example, your bank might charge merchants higher fees to process transactions through it.
How to avoid bank interchange fees
Bank interchange fees are nearly impossible to avoid since most merchants account for them when pricing goods and services. However, some retailers offer lower prices when consumers pay with cash. Those opportunities are worth looking out for.
Interchange fees also explain the incentive banks have to encourage credit and debit card transactions. Those rewards points aren’t free. Make sure you aren’t making purchases simply for the sake of racking them up.
General tips for avoiding bank fees
Now that you know how banks make money, here are some ways to prevent them from doing so at your expense.
You’d be surprised what banks are willing to do when you simply ask nicely. I’ve gotten everything from cash advance fees to overdraft penalties (I know, shame on me) waived using this strategy.
Banks are flexible in large part because their customer acquisition costs can be as high. According to Tearsheet, a large bank might spend as much as $2,000 obtaining a new customer. They don’t want to nullify that investment by being inflexible on fees and seeing you leave for a cheaper competitor.
Give fintech startups a try
As I’ve mentioned in passing a few times throughout this article, big banks no longer have a monopoly on the financial services sector. There are many startups offering banking and investment services at competitive rates. Thanks to these startups, gone are the days when banking had to be expensive.
Companies I find interesting include:
Use a financial tracker that checks for fees
Banks can be sneaky. They’ll hit you with small, easily overlooked fees here and there. Thankfully, there are automated tools that can spot these transactions and alert you.
I use Mint for this purpose. Whenever a fee hits one of my connected accounts, Mint sends an email inviting me to investigate.
Truebill goes one step further, not only alerting you of fees but also helping you recoup them if possible.
Keep track of your spending and account balances
If you have multiple bank accounts, keeping track of your transactions and balances can be tough. Tools such as Mint and Truebill can also help here by consolidating your records and making it easy to tell when you’re about to incur a fee.
For example, you can set a low balance alert in Mint to avoid being hit with an insufficient funds fee.
How do banks make money? Conclusion
I hope this article has been helpful in highlighting some of the ways banks make money and how you can avoid being taken for a ride. Check out more of my personal finance articles here.