Personal Finances: How banks really work
Why do we feel much better about having our savings in a bank than we do having it hidden under a mattress? Is it just the fact that they pay interest on some of our accounts? Is it because we know that if we have the money in our pockets we’ll spend it? Or is it simply the convenience of being able to write checks and use debit cards rather than carrying cash around?
Bank deposits won’t help you become а millionaire, but they can be a very important way to hold on to your wealth. That’s why it is really important to understand how they really work.
TERMS AND DEFINITIONS:
-bank- an organization where people and businesses can deposit or borrow money, change it to foreign currency, etc.
-savings account – A savings account is an interest-bearing deposit account held at a bank or another financial institution that provides a modest interest rate. Financial institutions may limit the number of withdrawals you can make from your savings account for a given period. They may also charge fees, unless you maintain a certain average monthly balance in the account.
– checking account – A checking account is a bank account that allows easy access to your money. Also called a transactional account, it’s the account that you will use to pay your bills and make most of your financial transactions. A checking account at most banks is no different than a savings account: you’re lending the bank your money, but with a checking account, they substitute your interest for services (dealing with the checks you write, etc.).
-APY(Annual percentage yield). The amount of interest you gain from keeping money in an account in a year, including compound interest.
-APR (Annual percentage rate) The amount of interest you gain from keeping money in an account in a year, not including compound interest.
-compound interest – Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
-deposits- Bank deposits consist of money placed into banking institutions for safekeeping. These deposits are made to deposit accounts such as savings accounts, checking accounts and money market accounts.
HOW DO BANKS MAKE MONEY?
Everytime you swipe a card at a store, the merchant pays a small percentage of the money to the bank that issued the card, called an interchange fee. For credit cards this is around 1.7%, while for debit cards it is nearer to 1.1%. Given that most of the Americans spend more than they save, it is a huge revenue stream for the banks.
Have you ever wondered why your checking account is free? Obviously, it’s not because your bank is feeling charitable. Banks are never short of come-ons for winning new customers. Some banks offer new depositors free checks, cash bonuses and much more. That’s because banks can’t make money until they have your money.|
* There are 3 main ways bank make money
1. Net interest margin – Net interest margin (NIM) is a measure of the difference between the interest income generated by banks or other financial institutions and the amount of interest paid out to their lenders (for example – deposits), relative to the amount of their (interest-earning) assets.
When you deposit money into your bank account, you’re giving your bank permission to use your money to make loans. Your bank loans your money out to others at a cost to the lendee, in the form of an interest rate ( mortgages, student loans, credit cards, etc.). Banks collect money off the interest paid by borrowers, and a portion of that interest is given back to the depositor’s bank account.
2. Interchange – this is the term for the money banks make from processing credit and debit transactions. In other words this is a term used in the payment card industry to describe a fee paid between banks for the acceptance of card based transactions. Card associations, like Visa and Mastercard, facilitate the process. For the service they provide, associations collect a fee from the acquiring bank – this is what’s known as the interchange fees. In most cases, the interchange fee is comprised of a percentage of the total transaction plus some fixed amount (e.g. 2% + $0.10). While the card associations assess and determine the fees, they are paid to the issuing bank. The card associations instead collect a separate fee called the network fee. The network fee is usually far smaller – somewhere around 0.05%
3. Fees – Bank fees are nominal fees for a variety of account set-up and maintenance operations, as well as other minor transactional services. Fees can be one-time, ongoing, or related to penalties. There are plenty of different fees such as account fees, ATM fees, penalty charges, commissions, application fees, and others. In 2015, U.S.’s three biggest banks made $6 billion from ATM and overdraft fees, which is up to 20% of their total revenue. Many banks have been introducing new fees over the last year in response to a wave of new financial regulations. If you haven’t been paying attention to your accounts, you may be surprised to find new charges on your banking statements.
Banks make money by lending at rates higher than the ones they pay to deposit holders. They manage the whole process and keep the difference between the higher rate (interest on loans) and lower rate (interest on saving accounts). Having this in mind will help you better manage your finances. As a rule of thumb, once you cover your essential expenses, such as rent or mortgage, utility bills, student loans, etc., it’s crucial that you set aside a portion of your income into a savings account, emergency fund, or other investments. Make sure that you are able to set aside at least 10% of your disposable income and both you and the bank will have a safer financial future.
“It’s not your salary that makes you rich, it’s your spending habits.”
-Charles A. Jaffe