Wednesday, November 12, 2008

How Do Banks Make Money?

When my oldest son was 4 years old, he said to me, “Hey Daddy, we need some more money so let’s just to go to the bank and get some.”

You probably already know that’s not how it works. You have to put money in the bank before you can take money out.

Banks are businesses that hold money for people like you and your parents. When you give them money, that’s called a deposit. What do you think they do with it? They loan that money to other people. They pay you interest to be able to use your money. The people who borrow the money have to pay interest to the bank for lending them the money. The bank charges the people who borrow the money a higher rate of interest than they pay to you. The difference between what they make and what they pay you is income for the bank.

For example: When your parents bought their house, they went to a bank to borrow the money. Now the bank owns the title to your house and your parents make monthly payments to the bank in order to pay back the bank for the money they borrowed.

Where did the bank get the money to loan your parents? They got money from all the people who deposit their money in the bank. The bank tells these people, “If you let us use this money, we will loan it to other people who need it – and we will pay you for allowing us to do this.” Let’s say the bank pays them 2% interest. To the people who borrow the money, they say, “We will lend you money but you must pay us interest to use that money.” They charge these people 5%. The bank makes 3% on that money.

So if you borrow money from the bank, you must pay the bank back for the entire amount you borrowed, plus you also must pay an extra amount called interest.

Come back next week – and bring your friends. I’ll explain more about interest.