In order to understand the banking/interest system, you have to remind yourself of one thing: a bank is a business. They exist to make a profit like any other business.
Banks basically make money in two primary ways: fees & interest.
The fees come from overdraft fees, ATM fees, late fees, etc. But let’s talk about the interest system and how banks profit from it.
Let’s say you deposit $1,000 in a basic savings account at your local bank. If you’re lucky, you might get a 1% interest rate (it’s more likely to be 0.5% or so). What that means is the bank is going to pay you a 1% fee for the opportunity to use your money. So if you deposit $1,000, over the course of the year, they will pay you $10 in interest. Not much, but it’s better than nothing.
But what do you mean they pay me for the opportunity to use my money?
A key business for a bank is making loans. Car loans, home loans, business loans…you name it, banks loan people money for it. So let’s say after you deposit your $1,000 in the bank, someone comes in and wants to take out a loan for $1,000. The bank approves the loan and is going to charge them 5% interest to borrow that money which the bank says has to be paid back in 1 year. So 5% interest on $1,000 is $50.
Do you see what has happened? The bank essentially pays you $10 (1% interest) to use your $1,000, but then loans it out at a 5% interest rate and makes $50 in the process. So after they pay you your $10 from the $50 they made, they keep $40 profit. Now you multiply this out with banks collecting deposits and loaning out literally millions and millions of dollars, and you can quickly see how banking can be a pretty lucrative business.
The risk in banking though is what happens when the person that borrowed $1,000 doesn’t repay it? That’s what we’ve seen happen over the last year in the housing market. People borrowed money to buy houses but when they couldn’t repay the loan, the bank would take ownership of the house (also known as foreclosure). So now a bunch of banks own a bunch of houses. But they don’t want to own houses…they want to own money!
YOUR 2 CENTS: What other questions do you have about the banking/interest system?
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Oh and then you forget the fact that banks are able (by law) to make loans of at least 10x the amount you give them. If you provide them with $1,000 then they’re able to create loans to other people for at least $10,000 at a 5% interest rate. So when they pay you $1 they’re making $500 from their customers. Nice profits right?
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