During my school and college years, I often used to wonder– “How do Banks make money?”. I did not however put a lot of effort in understanding the subject and naively assumed that the government was running banks in order to provide services to its citizens and to shore up the country’s infrastructure. It was only over time, that I realized how wrong I was! .
Banking is a purely profit oriented business, Just like any other business – It has its own costs and income streams. In today’s article, I would like to give you some idea of the various ways a bank earns income and makes profits. We will also talk about expenses in the banking business and hopefully provide you with a holistic view of banking.
1. Earning money through Lending
This is the heart of banking business.
Lending to its customers is the biggest money-spinner for banks. The usual way this works is that banks accept deposits from their customers (through savings bank account, fixed/recurring deposits), providing the bank with a big pool of money. Now this pool of money is then used to lend to customers who need loans.Its very obvious that not all the money deposited will be withdrawn the next day itself. If a bank has Rs 100 as deposits, not more than Rs 10 is often needed to repay back to customers, which means Rs 90 can be lent to those who are ready to pay high interest and have repayment capability.
High Interest Charged, Low interest paid
Now, riskier the loan, higher the interest charges it carries, so that in the event of a loan going bad (called as NPA – Non Performing Asset), the huge interest charged more than makes up for the loss incurred by the bank. This also explains why home loans and education loans (which have security deposits – if you cant repay, the home is there to sell off and recover the loan) have comparatively low interest rates compared to loans that are totally unsecured (e.g. personal loans or credit card debt). That explains which why CIBIL report containing high number of unsecured loans do not get loans, because they give an impression that they are so much dependent on credit in their financial life.
Anyways, To put this concept in simple terms, banks make their money by paying interest to depositors at about 4% (saving bank account – the low interest rate is because you can take out the money anytime) or 8% p.a (in FD or RD, because of some kind of lock in there, and a kind of approval by you that you will leave that money for a long time with bank and not withdraw in short term), while they give out loans/credit and earn interest themselves about 12-13% p.a. – thus earning the 5% spread in between. When you further deduct from this, the significant overhead expenses banks have to pay (like rent for offices, salaries to employees and other costs), what you are left with is the profits of the bank.
This also answers a common question – how banks make money on credit cards?
In case of credit cards, a few bad customers who do not pay on time, pay huge interest charges (3.5% monthly or more than 40% years) and late payment fees, which are good enough to make up for the services given to a good customer who is paying on time and availing the benefits of the card. That should answer those who ask – “How can banks afford to give me a credit for 40 days?” – Its not the bank , but those bad customers who are helping you to get that free credit ! – they pay the BIG charges.
2. Earning money through Services and Products
The other way banks earn money is by providing lots of services in addition to their core banking products. For example, when you open an account, you do not pay for basic services such as banking, transactions on an ATM machine and getting a chequebook.
However, if you need more than these basic features, you will have to pay for them. Such “extra” things are
- Extra cheque book in a quarter
- Feature rich credit cards with yearly fees
- More account statements other than the default you get
- NEFT/ RTGS charges
- Charges for SMS notification
- Processing charges for giving loans
There are all some examples of these paid services.
Why banks keep distributing credit cards ?
I was also curious about the eagerness displayed by banks in providing consumers with credit cards – what made them do so and how were they benefiting from it. I came to the realization later that the greater the frequency of a customer’s credit card use, the more money banks make. This is because every time you swipe your card at a shop,the bank which owns the swipe machine pockets a cool transaction fee of up to 1-2% of the transaction amount. That explains why these days banks are tying up with e-commerce companies to provide “Swipe on Delivery” service to customers other than “Cash on Delivery”
So imagine if you swipe your card for Rs. 10,000 in a month.The shopkeeper has to pay 1-2% of the transaction amount to the credit card company which owns the swipe machine (Break your 4 big myths about credit cards here). So 1-2% of Rs 10,000 is Rs 100-200. Now imagine millions of people swiping their debit/credit card each month over the years, and you can clearly visualize how much money banks make (Of course these banking services have their attendant expenses including the cost of the swiping terminals, employee salaries, rental/ purchase charges for the bank premises and other general administrative costs). So it make sense for banks to keep giving credit cards and debit cards to anyone who has potential for spending and repaying it back 🙂 . So your SPENDING creates INCOME for bank 🙂 .
Here is a detailed note of how banks money when you swipe your debit or credit cards on terminals – Thanks Vivek for the explanation
Do you know why Banks market Credit cards aggressively and give to all and sundry. It is because its one of the highest revenue generating asset for the bank. The interest rates on Credit cards are as high as 3.4% per month (APR 41%), plus service tax of 12.36% on the interest portion, effectively taking it to 3.8% pm (APR 46%). But did you know, that credit card companies have another income stream. It is INTERCHANGE FEE.
For every Credit card transaction done by you, the bank gets fixed 1.1% of the transaction amount as Interchange fee (APR 132.2%). Who actually pays this fee.
The merchant installs a POS terminal called EDC Machine at his place. Customers charge bill to their credit cards on the merchants EDC machine. The merchant in turn submits the charges to his bank called “Acquiring Bank” who acquires the charges. The Acquiring banks pays the merchant the transaction amount, less commission called Merchant Service Fee or Discount rate which is in the range of 1.6 to 4%. Typically, it is 2%. The Acquiring bank presents these charges to the Issuer bank through clearing mechanism, and gets the transaction amount, less Interchange fee. All in all, Credit card is an important folio for banks. The Customer should use to card to his advantage.
It is not free money and if one misuses it, he will have to pay through his nose. I would suggest one to have a Credit limit of not more than Rs.35,000/- or at best Rs.50,000/-. The maximum cards should be restricted to 2. Remember, Credit card debt is a TOXIC Debt. One is better off using Debit card. Interest free Grace period should not be a criterion to have a credit card.
Were you aware about these points? Lets discuss more about this in comments section. Please share your views on this topic!