How Do Banks Make Money? The Importance of Earning Interest on Your Savings

Think about the last time that you signed up for a bank account. What made you choose that bank? They probably offered you a free checking account or a free cooler or a sweet gift card as part of the deal (and who doesn’t love free things). Maybe a better interest on a cash advance?

But if banks are offering free checking accounts, giving prizes away, and giving some percentage rates of return to your hard-earned savings, how are they making money? Aren’t they just there to keep track of your cash and ensure that it stays safe?

Not surprisingly, banks certainly aren’t offering all of these perks due to their generosity—and that includes the given service of knowing that your money is accessible and secure. There’s a method to the madness when it comes to the services that banks offer and the incentives that they use to get your money through the door.

That’s because they need your money in order to start making money of their own, and knowing how they make their money will help you make your money work for you. Banks can’t even start generating an income until you sign up for an account and start making deposits—which is plenty of incentive to offer all of those nice little perks. In this article, we’ll talk about the different ways that banks make money and how that affects you (especially when it comes to the interest that you earn on your savings).

Banking 101: How A Bank Makes Money

When it comes to making money from money, there are plenty of ways for banks to turn a profit. There are three ways that a bank can make money: through account-related fees, loan interest, and interchange fees.

1. Banks Make Money with Account-Related Fees

We’ve all been there: your bank account is dwindling, your next paycheque hasn’t hit yet, and you really need that morning latte to make it through your commute to work. That purchase ends up charging $3 more than what you had in your checking account.

Sure, the bank will cover you and still allow the charge for that latte to go through—but it will cost you anywhere between $10 to $35 just to process that tiny charge (and let’s be honest, no latte is worth that kind of money). Just ask any credit counsellors. They know too.

Overdraft fees are a big money-maker for banks. In 2017, U.S. banks made over $17 billion from overdraft fees alone. And there are tons of other account fees that fall into this umbrella for banks and credit cards alike, such as:

• Maintenance fees for not keeping a required minimum balance or failing to meet the requirement for transfers/deposits
• ATM fees for using ATMs outside of your banking network
• Late payment fees on loans or credit card balances. Which can effect your credit score.
• Application fees for financial products like loans or lines of credit

If you’re investing with your bank, you’ll get charged commission fees as part of the normal cost of making investments. And because many banks have higher overhead to pay for in a physical location, such as rent, electric, and water, that cost might be higher as a result.

2. Banks Make Money from Loan Interest

Part of the reason that banks can offer interest-bearing savings accounts and other financial products is because they are making a much better profit on their lending products. And here’s where your money comes into play: banks use a percentage of your money to fund mortgages, personal loans, student loans, credit cards and more.

(And before you start to panic about your money going to someone else across the country, don’t worry—banks don’t use all of your money to fund loans. The federal treasury puts limits on how much of your money a bank can lend out, and you’re always able to withdraw your full amount.)

Think of it this way: if you put $100,000 in your savings account with a 1 percent interest rate and don’t touch it, you’ll get $1,000 back after a year. But if bank takes that $100,000 to fund a mortgage with a 3 percent interest rate, they are making $3,000 just for providing a one-time loan. And that’s just one year. Over the life of that loan, they’ll get thousands more. Lending is good business for banks—all made possible by the collective deposits of their customers.

3. Banks Make Money from Interchange Fees

Ever wonder why some stores or online retailers specify the cards that they will accept? Maybe you’ve found yourself asking if a merchant accepts American Express or Mastercard. And some smaller businesses might not take credit cards at all.

All of this is due to interchange fees—you might not have an additional cost to swipe your card, but the merchants do. It costs them money to process your credit and debit cards. Those small fees are paid by the merchants and go directly to the issuer of the card (in this case, your bank) to cover related costs such as fraud coverage or any risk that might be involved in allowing card payments.

If you’re swiping your card more often, the bank will get more income from the interchange fees—which is why rewards-based cards can be so lucrative for banks and credit card companies.

Earning More Money On Your Savings: Why Does It Matter?

Whether you’re setting up a savings account for a rainy day or for a more specific goal—like a vacation, education, or retirement—you’ll want to make sure that you are earning as much interest as possible. After all, if you’re going to put money aside (and letting your bank use it for loans in the process), you might as well earn a little extra while you are doing it!

Interest is a great way to get “free” money back, where the only cost on your part is agreeing not to touch it over the long term. There are two ways that you can earn interest on your hard-earned savings: through simple interest and compound interest. And the difference between the two is pretty significant:

Simple interest means that your interest percentage rate (i.e., how much money you are getting back from the bank simply for keeping your money there) is based on the principal amount. So the amount that you put into your account is the amount that earns you interest. If you deposit $1,000 and have a 1 percent interest rate, you’ll have $1,010 at the end of the first year, $1,020 at the end of the second, and so on.

Compound interest gets you a much better deal. With compound interest, you earn money back not only on the principal, but also on the interest that you earn. In that same scenario, if you deposit $1,000 with a 1 percent compounded interest rate, you’ll still end up with $1,010 after the first year—but the next year, your interest rate will be calculated based on $1,010.

Compound interest includes the money you earn through interest, rather than your first deposit. Not only are you maximizing your saving power, but you’re also protecting your savings from the effects of inflation (which can easily make that 1 percent interest rate ineffective). The key to it all is long term thinking and staying calm. Time in the market beats timing the market as they say.

No matter what kind of savings account you choose, how much you deposit, or what your savings goals are, the best benefit to earning interest on your savings is that you can make your money work for you with minimal, if any, effort on your part. Earning interest makes smart financial sense for your long-term health—and if your bank is willing to pay you for the privilege of storing (and using) your money, you might as well take advantage of it!

Once you understand the basics of how banks make money—and how your interest is calculated—you’ll be well on your way to ensuring that your savings account is set up for long-term success. Make sure you shop around for the best savings interest rates and factor whether or not it is a simple interest or compound interest rate! If you want to pay off debt before you start saving, you may want to consider a short-term loan from My Canada Payday. We are proud to be one of the best payday lenders in Canada, and we love helping borrowers get back on their financial feet! Give us a call at any time (604-630-4783) or shoot us an email (getpaid@mycanadapayday.com) to speak with our industry-leading customer support team.