Our goal at Peoples Bank is to provide access to personal and business banking services and help the people in our community through quality services and outstanding customer service.
Banks provide a convenient service—storing your money which keeps it much safer than it would be in your house. But have you ever wondered how banks are able to offer this service for free (or with very small fees)? A business is supposed to charge people for its service, but banks actually pay you interest for the money in your account. How does this work?
How Banks Earn Money—Fractional Reserve Banking
People sometimes picture banks as having a giant vault in the back where they store all your money. You deposit three hundred dollars, and the teller takes it back to some massive safe and stores it in a box with your name. This image is incorrect, however.
While it’s true that banks do hold large amounts of money, most of what you’ve deposited at the banks is not kept physically in the building. Instead, banks keep a certain percentage on hand then loan the rest out. This is where banks get money for home loans—the cash people have stored in their accounts.
This is called Fractional Reserve Banking, and it has been an integral part of modern economics for over a century. Without it, people would have a lot more difficulty taking out loans for houses or cars, and small businesses would have trouble finding money to borrow.
Imagine if you were trying to start a business (which would give people jobs) and needed to borrow some money to get started. Without banks, it would be much harder to find a loan. Where would you go? Banks make it easier for aspiring business owners to get off the ground.
Lending, Risk, and Interest
When a bank loans money to someone, the bank is taking a risk. There’s always a chance that the person they’re lending to won’t pay them back. In return for taking this risk, banks are compensated through interest, a small percentage that the borrower pays on top of what they borrowed. This is where banks make their money, and that is why they are able to pay you interest on the money in your account. You receive that interest is to compensate you, because when you deposit your money in a bank, you are loaning to them.
However, nowadays when you lend money to a bank, you take virtually no risk. Even if the bank with your account fails and goes bankrupt, you’ll still get your money back. This is because of accounts being…
FDIC Insured
In the 21st Century, it’s very safe to keep your money in the bank. For the average person, it’s almost impossible to lose the money in your account. But this wasn’t always the case.
In the 1920s and 30s, banks had a big problem. The fractional reserve banking system had allowed for massive economic growth, but it had a huge drawback. The problem was—what happens if everyone wants to withdraw their money at the same time?
Since banks—in order to function—have to loan much of the money people deposit, they don’t have enough on hand to pay every single customer if they all decided to take out their money at once. Customers knew this, so whenever the economy turned bad, people would become nervous that their bank would fail and they’d lose everything, so they’d all try to withdraw all their money. If enough people did this, it would cause the very result they feared—the bank going out of business, unable to pay back their customers.
It was during this time that the government started a program that would stop people from losing their hard-earned cash and help prevent banks from failing. The government decided that if a bank failed, they would simply give all the customers their money back. That way, customers could lend to the bank without risk, because even if the bank failed, they wouldn’t lose a penny. This is called being “FDIC Insured.” Because of this, people would be less likely to panic and withdraw their money when the economy turned bad. This made banks much less likely to fail and in general made the economy more stable.
One note is that banks aren’t required to be FDIC insured, although most banks are FDIC insured. Banks can choose to sign up for that, and if they do, they will have to pay for it, so the money really is coming from the banks, not from the government itself, and therefore not from your tax dollars. So not every bank is FDIC insured. Check to make sure your bank is FDIC insured. Also, some types of investments, like stocks, bonds, and mutual funds, are not protected. Learn more information here: https://www.cnbc.com/select/fdic-insurance/
Another important detail is that accounts are only insured up to $250,000. So, if you have money in a bank, and the bank fails, the government will pay you back every penny up to $250,000, but not more than that. If you have $300,000 in your bank account and the bank fails, you’ll only get $250,000 of it back. If you don’t have this much money in your account, you don’t have to worry about. This is also why people with a lot of money usually only keep part of it in the bank and keep the rest in various investments.
So, to recap—banks will keep your money safe for free (or nearly so) and even pay you interest because, in actuality, you are loaning money to them. They then loan this money to people for houses, cars, etc. Banks charge interest on these loans to make up for the risk of lending. When you have money in the bank, however, you take no risk (so long as you have less than a quarter million), because the government will pay you back if, for whatever reason, the bank fails.
The result is that everyday people have an easy way to borrow money to buy a home, and people have a safe and convenient place to store their money.