Any borrower who has taken out a loan with a bank or a lender has probably spent some time wondering how on earth loan companies could afford to part with such a large chunk of change.
If you’re like me, you might imagine that your loan officer has to go into an underground vault in order to get the necessary cash for your loan, leaving the pile of money much smaller afterward.
You might surmise that there are only so many loans a particular loan company could give out before that pile of cash in the vault would be completely depleted — so how could your lender not only afford to give loans, but also make money off of them?
Thankfully for our economy, loan companies do not keep piles of cash in underground vaults for borrowers. The reality is that lenders rely on money to make money, but it’s not as simple as a basement full of cash. Here’s a breakdown of how loan companies are able to lend to borrowers and make a profit.
Loan companies start with investors
While your loan company doesn’t have a physical pile of cash, there does need to be an influx of money before lenders can start offering loans. That money comes either from investors or depositors.
For instance, when your weekly paycheck is direct deposited in your bank, that money becomes part of the capital the bank uses to make loans to borrowers.
Investors (or banking customers who are depositing money) are effectively lending money to the bank, for which they will be paid back interest. Bank depositors will receive much lower interest rates than investors because they reserve the right to withdraw their full balance at any time, whereas an investor is generally giving up access to their money for a certain term.
You’ve probably noticed that the interest investors or banking customers are paid is lower than the interest rate that the loan company or bank charges borrowers. That difference, known as the net interest margin, is where lenders make their money.
Banks profit from the difference between what they earn in interest from borrowers and what they owe in interest to investors and depositors.
Considering the fact that banks and loan companies are in the business of making as much money as possible, why don’t all investors and depositors receive minuscule interest rates, and why don’t all borrowers pay ginormous interest rates?
Even though a bank is free to set its own rates, it also has to take several other factors into account.
1. Federal reserve monetary policies
The United States Federal Reserve influences interest rates in a variety of ways, including setting the federal funds rate (the interest rate banks use to borrow and lend with the Fed and each other). The federal funds rate helps to set the “prime rate,” which is the interest rate a bank would charge an ideal, credit-worthy customer.
The market levels for interest rates among various banks and lenders help each loan company determine its rates. If a lender has the poorest rates in town, no one will want to invest or borrow from them.
3. Inflation and market volatility
Banks must look at the cost of inflation and potential market volatility of the life of a loan, particularly for long-term loans. The interest rate charged to a borrower has to take into account how much inflation might eat into the bank’s net interest margin.
In addition, fluctuations in the market can affect how much a dollar is worth and whether customers will be looking to either invest or borrow.
How loan companies inject money into the economy
One of the most fascinating aspects of the lending process is how it’s able to use investors’ money to “create” more money. Here’s how:
Let’s say an investor named Harry comes to the bank and deposits $10,000 in his savings account. The bank keeps $1,000 in reserve. The following day, a student named Sarah takes a $9,000 student loan from the same bank.
By lending out the $9,000, the bank has effectively doubled the money in the economy, since Harry’s $10,000 is available to him and earning him interest in his account, while Hermione’s loan is purchasing her $9,000 worth of education.
Don’t forget the fees
Of course, the net interest margin is not the only way that banks and loan companies make money. Fees can also be a source of profit, and something that the consumer needs to be wary of. In particular, you are likely to see the following types of fees among loan companies:
When a borrower applies for a loan, he will often be faced with an application or loan origination fee. Sometimes you will pay this out-of-pocket, and sometimes the fee will be included in the principal of your loan, which means you will also be paying interest on it.
These fees are generally on the depositor and investor side. You might pay an account fee for a checking account, an investment account, or a credit card as a maintenance charge.
Using an ATM under another bank’s name will cost you. Often, you’ll pay a fee to the bank that owns the ATM, as well as a fee to your bank.
These fees generally occur when you do things like overdraw your account or make a late payment on a loan.
Even though some of what banks do may seem magical, it’s important for all consumers — both borrowers and investors — to understand the simple ways loan companies and banks make their money. Armed with this knowledge, you can recognize and avoid unnecessary fees and limit your interest payments.
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