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What’s a Commercial Bank?
A commercial bank is where most people go to do their everyday banking. Commercial banks give businesses and individuals a place to store their money while having access to credit and loans. Again, since one of the reasons a bank operates is to make money, most financial institutions focus on profits from the same customers they serve day to day.
Commercial Bank Definition
According to Bankrate, a commercial bank is viewed as a “for-profit financial institution that accepts deposits, offers loans, and provides other financial services to its customers.”
A commercial bank’s money essentially belongs to its customers, who can withdraw their funds at any time, even on short notice. Because of that, commercial banks offer credit for shorter lengths of time with the backing of real, concrete securities that are easy to sell.
Now that you know what a commercial bank does, the truth still stands: most of us have no idea how banks really make a profit. When you consider the fact that a bank holds onto your money — and that of other customers — how do banks actually afford to keep the lights on, remain in business and turn a profit?
Here’s a 101 primer on how banks make money and have the ability to lend that money out to their customers. Read on to learn more!
How Banks Make Money
When you open a savings or checking account at a bank, your money doesn’t just sit there.
Every time you make a deposit, your bank “borrows” the money from you to lend it out to others. Think about all those auto and personal loans, mortgages, and even bank lines of credit. Sadly, money doesn’t grow on trees, so the bank uses your money to help fund these loans temporarily. In turn for your generosity (that most of the time you are unaware of), you get paid back in the form of interest — sort of a courtesy for trusting that financial institution with your money.
Bigger banks are also often made up of separate branches that focus on different types of customers and services. For example, commercial or retail banking branches may offer more common bank services, such as checking and savings accounts or giving out personal and business loans.
If you belong to a credit union that isn’t motivated by profit margins, you may see more interest paid to you. Or, in the case of an online checking or savings account, there are no branch locations and minimal overhead costs. This means that you may see more money in the way of automatic savings and other perks.
At this point you might be wondering: How can money in the bank be loaned out and available to withdraw at the same time? Don’t worry. Your money hasn’t vanished on you. Banks don’t lend out all the money they have on deposit. They’re required to keep enough money on hand to handle transactions and withdrawals. Your funds are also protected and insured by the Federal Deposit Insurance Corporation (FDIC).
Where Do Banks Get Money to Lend to Borrowers?
Now it’s time to look at the several different ways banks make a profit to lend to their customers.
When you deposit money in your bank account, banks use that money to loan out to other people or businesses. The banks charge them interest, which they collect as their profit.
The bank pays you a certain amount of interest in exchange for keeping your deposit. However, they collect even more interest on the loans they issue to others, and this is where they make most of their money.
If you’re on the borrowing side, banks lend money to you and receive extra interest when you repay the loan. Many banks make the majority of their money from charging interest on loaned funds, such as home loans, auto loans, or personal loans that are issued to consumers. Many banks also offer loans to small and large businesses. Customers who have a credit card and revolve a balance may also pay interest on their credit card debt.
A defaulted asset is an asset that is 30 or more days delinquent in the payment of principal, interest, fees, or other amounts payable under the agreeable terms of the item.
A common banking practice is to sell or auction off items put up as collateral on defaulted loans. This may be a house that’s been foreclosed on or a car that’s been repossessed. So, where does the unclaimed collateral go? You guessed it. The money garnered from the sale or resale of the items is funneled back into the bank’s budget.
Another huge portion of a bank’s monthly income is made off of various fees paid by their customers. Oftentimes, for example, banks charge account maintenance fees or penalty fees if your monthly balance falls under a specified amount. Fees are attached to everything from account transfers to canceled checks. And, of course, there’s the dreaded overdraft fee for those times you might try to spend more money than you have in your account. In fact, in 2019, large banks made more than $11.68 billion from customers in bank fees, particularly from overdraft fees. Depending on the type of credit card you have, you may also be responsible for an annual card fee, and that’s not counting late fees or inflated interest rates if you carry a balance from month to month.
Brick-and-mortar banks may also charge teller fees, fees to obtain bank statements, vault and safety deposit box fees, and other application and loan fees. This may seem like too many fees to handle, but remember, not all banks are fee-driven, and choosing the right place to hold your money is important to your financial success.
Interchange fees are the amounts paid between banks for the acceptance of card-based transactions.
For example, if you use your debit card to make a $20 transaction, $20 is withdrawn from your bank account. But that’s on your end. Merchants, on the other hand, are typically charged a transaction fee by both your bank (the card issuer) and the merchant’s bank for electronic payments.
This is yet another way for financial institutions to make money. Interchange fees are also a way your bank/card issuer can afford to come up with the money to pay out credit card rewards, like cashback.
Additional Ways Banks Make Money
There are other avenues banks take to make their profit, such as:
- Investing their funds — In addition to making money on customers’ investments, banks invest their own money to turn a profit.
- Advisory or consulting services — Banks can also make money by becoming an adviser or consultant for outside businesses by assisting them with financial goals and strategies.
- Earning commissions — Banks may have partnerships or relationships with other financial institutions like brokerages and investment services that pay them a commission to refer their customers.
Where Do Banks Put Their Money?
Banks typically don’t stash away your money. They actually quickly lend it out to someone who can use it when you don’t. Again, no need to worry about getting your money when you do need it.
Your funds are protected, and the government would step in if your funds were for some reason not available. However, there’s a limit to how much deposit insurance covers. In the U.S., it’s $250,000 per account. Anything over that amount raises a bigger question, but if it’s anything less, you’re covered.
The money the bank does keep on hand for withdrawals is usually kept in safes or vaults on site. The remainder of their funds are tied in investments, being used to pay bills or being loaned out to customers of that bank.
What’s the largest source of income for banks?
The largest source of income for most banks is the interest earned from various loans or credit cards used by borrowers. It’s always a good idea to be conscious of the interest rates on credit cards you apply for or on the loans you are taking out. High interest rates could accumulate large amounts of debt for yourself, and large amounts of money for the bank to keep in their pocket.
When do banks make money from deposits?
When you deposit money in the bank, you receive a rate that is under the prime rate on that deposit. In today’s market you might be making about 3.2%, which is to encourage you to leave your money in the bank, where the bank has access to use it.
In the meantime, the bank lends your money out through a variety of ways, all at an interest rate over the prime rate. Even though the bank doesn’t own the money that is deposited or lent out, it makes money on, guess what? The interest payments!
Where do banks invest their money?
There are over 6,000 commercial banks that accept deposits and invest those funds within the guidelines given by federal and state agencies. Banking institutions are required to maintain reserves up to 10% of their deposits. The remainder is usually invested in real estate loans, commercial and consumer loans, and government securities.
As you’ve now learned, banks make their money in many ways. Several of these factors may cross your mind when choosing where to store your finances.
However, keep in mind that banks are also in the business of making you money. Remember, the relationship between you and your bank of choice should be mutually beneficial, where it’s able to make its money without making you incapable of reaching your financial goals, especially at the bank’s expense.
Ready to make that decision? Check out the Chime Spending Account and see if it’s the right move for you and your hard-earned cash.