How Do Banks Work? [VIDEO]

Rogelio Valdés

Dec 27, 2020

How do banks make money?

Have you ever wondered how banks make money? Banks hold the money of millions of people, but what do they actually gain from keeping all that money? To answer that question, it helps to understand credit, investing, and interest. You can learn more about those topics in our Finance Course for Children and Teens, but in simple terms, a credit is a loan.

Credit and interest

A person goes to a bank and asks to borrow money to buy something expensive, like a car or a house. But why would the bank lend them that money? Is it just out of kindness? Of course not. Banks lend money because they make money doing it. The loans they issue come with something extra called interest.

Let’s say a bank lends you $100 and you are supposed to pay it back over 10 days. At first glance, you might think that means paying $10 per day. But not exactly. The bank might charge you $1 extra per day as interest. That means you would actually pay back $11 per day. At the end of those 10 days, how much did you give the bank?

By the end of the period, the bank would have received $110, which is $10 more than they originally lent you. That may not sound like much, but banks issue loans worth millions every day around the world, each one with different levels of interest.

So interest may sound like a complicated word, but really it just means the extra money charged in exchange for lending you money.

Where does the bank get the money it lends out? Most of it comes from the savings of other people. When we put money in the bank, we are also allowing the bank to use that money to make loans. In other words, the bank is effectively investing through other people.

In return, banks may also pay us interest because they are using our money to lend to others. Out of the $10 the bank earned by lending money to one person, it might give us $1. The more money you have in the bank, the more the bank can lend out, and the more interest it can generate.

This can sound like a very easy way to make money, but if you have already seen Robin Academy’s lessons on loans and investing, you may have noticed the weakness in this business model.

Investments and their risks

How do banks know people will actually pay them back? If someone is asking for credit, that usually means they do not already have enough money to easily buy whatever they need. Maybe they have a stable job and just did not have time to save for it, maybe they need a car for work, or maybe they are borrowing to start their own business. But what happens if they lose their job or the business fails? Then they may no longer be able to repay the bank, much less the interest.

In more extreme cases, someone could even take out a loan with no intention of paying it back, for example a fraudster or a thief.

To reduce the risk of losing money, banks do not give credit to just anyone who asks for it. They rely on credit history. They review a customer’s track record: whether they pay their credit cards on time, whether they pay utility bills without delay, whether they have borrowed before, whether they have a stable salary, how much money they keep in their account, and many other signals. Banks look at a wide range of factors to try to make sure they will get their money back.

What happens when someone intended to pay but simply could not? Depending on the contract, banks may be able to take property worth the same or more than the amount borrowed. That can include things like a house, a car, a business, or another asset that serves as compensation.

All of this can make it sound like banks cannot make mistakes, as if banking were a perfect machine that can only make money. But all investments carry risk. Even with safety measures like credit history, banks have made and will continue to make loans to people who ultimately cannot repay them.

Cards and ATMs

Beyond interest on loans, banks also earn money in other ways. Think about bank cards: that convenient piece of plastic that lets you pay without carrying cash and withdraw money from an ATM.

To simplify things, imagine that each time you use that card, or almost any banking service, the bank earns a tiny percentage from the transaction. It is a fee that most people barely notice. But when thousands of people use these services every day, banks can earn enormous sums each year.

So in conclusion, banks are not storing money out of generosity. They make money by investing through people, lending them money, and charging interest.