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How Do Banks Make Money?

Banks typically make money in three ways: net interest margin, interchange, and fees. Here’s how that can affect you.

Articles by Bobby Glotfelty

By Bobby Glotfelty
Licensed Financial Professional, Betterment  |  Published: October 30, 2019

Banks generally make money in three ways: interest on loans, interchange, and fees.

Online banks can allow for more convenience, higher rates, and lower fees than traditional banks.

Betterment Everyday™, while not a bank, is a cash management suite that can help you live better.

Have you ever wondered how banks make money?

Banks make money from their retail customers, people like you and me, as well as from merchants: department stores, retail outlets, restaurants, bars, etc.

They charge customers interest on loans they provide, as well as service/account fees. They make money off of merchants every time a customer of that merchant uses a debit or credit card at its place of business; the fee merchants pay banks is called an interchange fee.

Below is a breakdown of the three big ways in which banks make money: net interest margin, interchange, and fees.

Net Interest Margin

Customers make deposits into banks and the banks typically use most of those deposits to provide loans (home, auto, student, etc) for other customers. These loans have interest rates tied to them that customers need to pay in order to get the loan in the first place.

This means that the money earned on these loans is revenue for the bank, and some of that earned money is given back to customers in the form of interest within checking and savings accounts. The money that the bank keeps is considered the net interest margin: put another way, the difference between how much the bank earns on their loans versus what they payback to customers is their net interest margin.

For example, someone can get a $100,000 mortgage from a bank, but it’ll come with an annual percentage rate (APR) that the customer needs to pay in order to get that loan. The APR is the cost to borrow $100,000 from the bank.

To illustrate, you can get a 30 year fixed rate loan for a 4% APR. On a 30 year loan, the customer will pay roughly $72,000 in interest to the bank. Then, the bank will give some of that earned interest to their customers’ checking and savings accounts. The amount left over is the banks’ net investment margin.

In reality, there are all sorts of loans with varying interest rates. Another common example is credit cards.

When people don’t pay off their credit cards in full, they are charged interest on the balance of their credit card. The APR that people pay for credit cards can range anywhere from 0% to upwards of 25%. The money (or interest) the banks earn on these unpaid credit cards is another example of  banks loaning out customers’ deposits, earning money on those deposits, paying some of that money back to customers checking and savings accounts, and pocketing the rest.

Interchange

Whenever you use a credit or debit card to buy something at a store, that store usually has to pay what’s called an interchange fee. Most of the interchange fee goes to your bank, and some goes to the store’s bank. This interchange fee covers the cost of handling credit and debit transactions.

Interchange fee rates are set by credit card companies. Among other factors, interchange fee rates can vary by provider, but the way in which they are structured is that it’s a percentage of the transactions plus a flat rate.

For example, if the interchange rate is 2.00% + $0.10, and someone bought a $100 item, the total interchange fee the store would pay would be $2.10. The store would get $97.90 of the actual purchase and the $2.10 interchange fee goes to the bank that provided you the credit card.

When you go into a store or restaurant and see that there is a card minimum, it’s most likely because of the interchange fee. The flat rate portions of the interchange fee for smaller transactions can really add up for businesses.

In the last few years, businesses have been fighting to lower the interchange fee rates and have had some success with capping interchange fees on debit card purchases.

Fees

Most people are familiar with banking fees. Banks find ways in which to charge their customers all sorts of fees. With many traditional banks, your checking or savings account agreement will have a long section listing out all the ways in which they charge you fees and penalties. If you’re curious, here is an example of a bank’s fee schedule.

Some common fees and penalties include: monthly service fees, minimum deposit limits, withdrawal penalties, ATM fees, overdraft fees, and foreign transaction fees.

Sometimes banks have so many fees, they have online guides on how to navigate all of the fees associated with your checking or savings accounts.

Some of the most common fees that people get hit with are ATM fees and overdraft fees. ATM fees have hit a record high for the 14th year in a row. Additionally, the average overdraft fee has increased virtually every year for the last 20 years.

Incentives don’t seem to be aligned for banks and customers when it comes to certain fees.

Banks could help prevent debit card overdrafts at checkouts and ATMs by denying the transaction or warning the customer, though doing so would eliminate the opportunity to charge the overdraft fee. Unsurprisingly, the majority of people would prefer that their debit card purchase get denied at checkout if it meant they would not get hit with an overdraft fee, according to the Center for Responsible Lending.

Traditional Banks vs Credit Unions and Online Banks

Traditional banks are generally older, legacy banks that have actual physical locations and are for-profit institutions.

Credit unions are nonprofit institutions, member owned and have physical locations. Credit Unions usually require qualifiers for membership, which can include factors like: being part of a community group, a specific employer, or living inside of a geographic location.

Online banks are a newer type of bank that may not have any physical locations; everything is online via a website and/or an app.

There are some key differences between traditional banks, credit unions, and online banks when it comes to how they make money.

Generally, traditional banks will make money in all three ways: net interest margin, interchange, and fees. Traditional banks are notorious for lots of fees and often provide relatively lower interest rates to their clients’ in savings and checking accounts because they keep a large chunk of its net interest margin, have higher expenses, and are for profit.

Credit Unions, similar to banks, will also make money in all three ways: net interest margin, interchange, and fees. However, they’re generally able to provide higher rates on savings and checking accounts and charge lower fees relative to larger banks. They’re able to do this because of their non-profit structure, size, and selective membership.

Online banks will make money in all three ways as well, but since they don’t have physical locations, they’re often able to provide higher interest rates on savings and checking accounts. Additionally, many online banks have less fees relative to traditional banks and credit unions.

How does Betterment Everyday™ make money?

Even though Betterment Everyday is not a bank, our cash management suite also makes money through net interest margin and interchange fees. However, this does not mean that there are additional account fees for users.

Betterment Everyday™ Cash Reserve has no fees on your balance.

Betterment Everyday Cash Reserve is our new high-yield cash account. While Betterment is not assessing fees from your balance, Program Banks pay a fee to Betterment Securities, which will be up to 0.25% of balances in Cash Reserve on an annual basis (without reflecting compounding). The APY figure in Betterment’s advertisements and daily rate displayed in your Betterment account already take into account the fee paid to Betterment Securities by Program Banks. The rates you see are the rates you will receive. Cash Reserve is provided by Betterment LLC, which is not a bank, and cash transfers to program banks are facilitated by Betterment Securities.

Betterment Everyday™ Checking has no monthly maintenance fees.

Betterment Everyday Checking has no monthly maintenance fees, no overdraft fees, no minimum balance, and ATM fees are reimbursed worldwide‡. In order to not charge you any checking fees, Betterment will make money via its interchange fee. This means that whenever you use the Betterment Visa debit card, Betterment earns interchange fees from merchants (just like any bank or credit union), plus a small amount of interest. Checking will be provided by Betterment Financial LLC, in partnership with nbkc bank.

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The Bottom Line

To recap, banks can typically make money in three ways: net interest margin, interchange fees, and banking fees. Traditional banks, credit unions, and online banks make money in utilizing all or a combination of the three methods. By better understanding how banks make money, you might find yourself learning how to look out for fees and understand if banks are truly working in your best interest.


Betterment Everyday Cash Reserve

Betterment Everyday Cash Reserve (“Cash Reserve”) is offered by Betterment LLC. Clients of Betterment LLC may participate in Cash Reserve through their brokerage account held at Betterment Securities. Neither Betterment LLC nor any of its affiliates is a bank. Through Cash Reserve, clients’ funds are deposited into one or more banks (“Program Banks“) where the funds earn a variable interest rate and are eligible for FDIC insurance.  Cash Reserve provides Betterment clients with the opportunity to earn interest on cash intended to purchase securities with through Betterment LLC and Betterment Securities.  Cash Reserve should not be viewed as a long-term investment option.

Funds held in your brokerage account are not FDIC-insured but are protected by SIPC. Funds in transit to or from Program Banks are generally not FDIC-insured but are protected by SIPC, except when those funds are held in a sweep account following a deposit or prior to a withdrawal, at which time funds are eligible for FDIC insurance but are not protected by SIPC. See Betterment Client Agreements for further details.  Funds deposited into Cash Reserve are eligible for up to $1,000,000.00 of FDIC insurance once the funds reach one or more Program Banks (up to $250,000 each at  up to four Program Banks). Even if there are more than four Program Banks, Clients will not necessarily have deposits allocated in a manner that will provide FDIC insurance above $1,000,000. The FDIC calculates the insurance limits based on all accounts held in the same insurable capacity at a bank, not just cash in Cash Reserve. If clients elect to exclude one or more Program Banks from receiving deposits the amount of FDIC insurance available through Cash Reserve may be lower. Clients are responsible for monitoring their total assets at each Program Bank, including existing deposits held at Program Banks outside of Cash Reserve, to ensure FDIC insurance limits are not exceeded, which could result in some funds being uninsured.  For more information on FDIC insurance please visit www.FDIC.gov. Deposits held in Program Banks are not protected by SIPC. For more information see the full terms and conditions and Betterment LLC’s Form ADV Part II.

Betterment Everyday Checking

‡ Checking accounts and the Betterment Visa Debit Card provided by and issued by nbkc bank, Overland Park, Kansas, Member FDIC. Funds deposited into Checking will be eligible for up to $250,000 of FDIC insurance. Betterment Everyday Checking made available through Betterment Financial LLC. Neither Betterment Financial LLC, nor any of their affiliates, is a bank. Betterment Financial LLC does not charge foreign transaction fees for the use of the Betterment Visa Debit Card outside of the United States. However, Visa charges a foreign transaction fee of 1%. Betterment Financial LLC does not reimburse this 1% transaction fee on foreign ATM transactions or on any other foreign transactions or purchases. Checking accounts do not earn APY (annual percentage yield). Betterment Everyday Cash Reserve and Betterment Everyday Checking are separate offerings and are not linked accounts.

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