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Are You Earning For Yourself Or The Banks?

Giving banks business may seem like putting yourself in harm’s way, but of course, it is still better hiding your money under a mattress! Your earnings are fruits of your hard work.

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Generations after generations rely on banks when it comes to financial management. From saving surplus amounts from our pay-checks to getting various financial loans in times of need, banks are our only best companions. 

Moreover, being lured by attractive interest rates provided by banks, we tend to believe that we are actually being rewarded for trusting a bank with our hard-earned money. Most of us are under the impression that if we entrust a bank with our savings, we can watch our money grow. But have you ever spared a thought on how a bank really works? They can't be offering to store your money for free, right? 

Big banks make big money

Come to imagine, your current account is offered to you for free, but that surely isn’t because your bank is overtly charitable towards all its customers, right? Big banks make big money. The kind of money that leads to hefty bonuses we are all aware of. But banks make money even when they’re not involved in big investment deals and billion-dollar hedge funds. Old fashioned “retail banking” (i.e., taking deposits and making loans) is quite a business by itself. Well, you see, banks are never short of come-ons for winning new customers; some banks offer new depositors free checks, cash bonuses or added perks to name a few. 

That’s because banks can’t make money until they have your money! So, it’s time to think, if you are really earning for yourself or for paying banks? For example, having a current account at the wrong bank can wreak havoc on your finances with unnecessary overdraft fees and customer service hassles!

Let us first understand how banks make money

Banks are businesses: they need to make money and they do this in a number of different ways. They are normally listed on the stock market and are therefore owned by, and run for, their shareholders. Therefore, they need to make enough money to pay their employees, maintain their infrastructure and run the business. There are three main ways banks make money: by charging interest on money that they lend, by charging fees for services they provide and by trading financial instruments in the financial markets. 

Commercial and retail banks raise funds by lending money at a higher rate of interest than they borrow it. This money is borrowed from other banks or from customers who deposit money with them. You must understand that deposits are the banks' liabilities. If everyone was to demand their money back at once, the bank would not be able to pay. Because they lend money out, banks are required to carry a cushion of capital so they have sufficient money to pay those customers likely to withdraw their money at any time. 

Every penny you save is every penny you lend

So, factually, every penny you save is every penny you lend. Retail and commercial banks need lots of customers to deposit their money with them, as the banks use these deposits to earn enough money to stay in business. To encourage people to keep their money in a bank, the bank will pay them a small amount of money (interest). This interest is paid from the money the bank earns by lending out the deposited money to other customers.

Lending loans to borrowers from the public is a major way for commercial banks to earn money. These could be a personal loan, home loan, car loan and other types of mortgages. The banks lend money to customers at a higher rate than they pay to depositors or than they borrow it. The difference, known as the margin or turn, is kept by the bank. For example, if a bank pays 1% interest on deposits, they may charge 6% interest on loans.

Let’s take a simple example. Person A does a fixed deposit worth 100,000 with a bank @8% annual interest for 5 years. Person B requests a personal loan worth 100,000 with the same bank. After checking person B’s credentials, the bank decides to extend the personal loan @13% annual interest for 5 years. The 5-year loan fetches 136,518 to the bank. At the same time, the fixed deposit matures and the bank pays 121,658 to person A. The difference between the two – 14,860 – is the bank’s income.

Customers fees for services

Banks also charge customers fees for services to do with managing their accounts and earn money from bank charges levied on overdrafts which exceed agreed limits. Commercial banks charge service fees for ATM’s, overdrafts, operating a simple savings account, issuing debit cards, renewing debit cards, accessing internet banking and mobile banking, issuing checks, maintaining bank lockers and more. So, basically, these fees are unavoidable since every commercial bank charges them, and no matter how careful you are with your earnings, you will end up paying a sum of it to the bank for just helping you manage your finances.

Now, how often do you get a call from banks to purchase a credit card? While the whole idea of having a credit card might sound alluring to you, you must be aware of how a credit card works in favour of draining your money to the bank’s pockets. Credit cards are unsecured loans extended by a commercial bank with the sole intention of earning heavy interest. Availing a credit card, limited or unlimited value, gives the person access to immediate funds and the person is charged premium fees by the bank for extending this facility. Initially, credit card issuing bank offer low late payment fees for the first year but from second-year onwards, the interest rates vary anywhere between 15% and 30%. Often, mismanagement of credit cards by the user leads to a huge debt, which ends up in a high windfall for the bank.

The Bottom Line

Recently, banks are taking a lot of heat for interest rate hikes and service fees are going out of control. Giving banks business may seem like putting yourself in harm’s way, but of course, it is still better hiding your money under a mattress! Your earnings are fruits of your hard work. So, before starting a relationship with any bank, understand how banks work. Thorough due diligence can help you avoid lining banks’ pockets by paying more interest than you are earning.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.


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banking

Sachin Mittal

The author is Founder and CEO, Loanwalle.com

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