Let’s Learn Finance: Banks and Interest

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Photo Credit: USNews.com

Amid the Wells Fargo scandal and Americans continued mistrust of banks, I figured it would be a good idea to tease out the details of what a bank is and how they make money. Almost all of us use a bank in some way. Whether to save money, or to borrow money, or to throw eggs at, banks are a part of our live.

Most of us deal with banks in the traditional sense, in that we place our money and trust in these institutions. The whole idea of putting our money somewhere other than under our mattress is something the banking industry has done a good job at persuading us to do. The main persuasion is interest.

According to a Quarts article, “Less than half of adults understand one of the key principles to making money grow: compounding interest”. Interest is a way to make money on the money you have without doing anything. And banks promise this interest so that savers are enticed to put their earnings into checking and savings accounts.

The benefit of compounding interest is that you can earn even more interest if you have already gotten some interest payments. As an example: if you have $100 and put it into a savings account with an interest rate of 10% (not a realistic rate), after the first year you would have $110. But compounding interest comes into play after the first year when instead of ten extra dollars, you would earn $11 in the second year (because $110 x 10% = $11).

So why are banks even willing to pay me money to put my money into their interest paying accounts? Banks want to entice enough savers so that they have enough money to then loan other people the money you have saved. The money that you put into a bank is not just kept in a vault somewhere, although some of it may be. Your money gets used to pay for a house, or pay for a car in the form of loans given out to other people.

Banks are able to do this because the interest that they charge people to borrow money is much, much higher than the interest you and I will receive on our savings. They usually will charge around 3-6% for a long term mortgage, but will charge even higher rates, like 15-20% on credit cards and shorter term loans. This is a huge difference to the abysmal 0.01% a lot of banks are paying to savers right now.

So the difference between the interest rate they have to pay us to save money and the interest rate people have to pay them to borrow money is the profit that they make. It is almost like free money. As long as they can continue to seem trustworthy to potential savers and manage the possibility of people not paying their loans back, banks can make easy money.

Now a lot of this is oversimplification, and I do want to emphasize that banks are very regulated so that consumers and savers are not in danger of being taken advantage of. But the basics of banks that we deal with from day to day is useful to know how they work. Why they are charging such high rates on credit cards, and why it is important to keep your money in a savings account for a longer period of time to see the benefits of compounded interest.

There are some great online banks that offer higher interest rates because they don’t have to pay rent for a building or many other physical expenses because of the internet. If you are looking to save money and use compounding interest to your advantage I would look at Barclay’s, Ally, or Synchrony for some good rates. The thing with any bank now-a-days is that if you have less than $250,000 in an account it is guaranteed by the FDIC (a government agency), so there should be no concern about getting your money back, even if your using an online bank.

There are also some new ways around the traditional way of asking for a loan  or credit card from a bank through peer to peer lending online. Prosper, The Lending Club, and SoFi are all good examples of what that can look like, and are ways to cut out the middle man of a bank, so that people (instead of banks) can earn the interest that loan payers will pay.

The way that we use money is becoming more and more digital and banks are changing their tune to keep up with the times. But we will all probably still be using banks in the future, and hopefully now we can use this resource with a little more knowledge about them.

If you missed the past posts in this series here are links to them:

Introduction
Goals and Budgets

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