How Banks Make Money

Posted By: Dr. Frugal in Saving on 09/29/2007 at 07:07:00

On the surface, it would appear that there is no way a bank could lose money. Your friendly banker gladly pays you a small (very small) percent interest on your savings, then turns around and lends those deposits out at several times the interest rate in the form of loans. It's the banking equivalent of buying low and selling high.

Of course, banking is much more complicated than simply paying depositors 3% interest and charging borrowers 9%--but the basic concept is valid. The difference between the 3% and the 9% is the spread.

As interest rates rise and fall, what the bank pays you for your savings will change, but so will what you have to pay for borrowed money. The two go hand-in-hand. Consumers can't complain about high interest rates for loans when they are getting high rates for their savings.

If you look at it from the bank's point of view, the bank has to buy money (yours) so it can sell (loans) to other people. Consider that as a consumer you count a bank certificate of deposit as a personal asset when figuring out your net worth. The bank, counts this as a liability because it has to pay interest and return the principal amount to you on a certain date. While your money is deposited, the bank gets to lend it out at a rate high enough to pay you the interest on your CD. The bank must valance when loans are due so it can count on having the cash available o return your CD's principal when it matures.


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