Updated: Oct 19, 2018
Have you ever wondered why your savings account is free? Or why banks run various promotions to persuade you to put your money there? Is it because banks are your friend? Haha, I doubt that! Big banks make big money off you in many ways. The credit card industry alone is a multi-billion dollar industry and is driven by consumer paying high interest and fees. The purpose of this article is not to convince you that banks are evil and to never host your money there. Banks provide FDIC insurance which guarantees your money (up to $250,000), so they do provide a truly safe place to keep your money. However, I do want to educate you on one of the many ways they profit from you and how you can limit this as best as possible.
When it comes to banks, “A dollar saved is a dollar lent.” A fundamental way in which banks make money is by using depositor’s funds to make loans. For instance, when you deposit money into the bank do you think they actually put it in a vault and keep it there until you need it? No way! Banks understand that sitting on idle cash is expensive (Learn more here ) so they earn money by lending your money out. In today’s interest rate environment, most banks are giving you .1% interest on most savings account (woohoo!). On the other hand, banks are then lending your money to someone for a mortgage at 5% earning a 4.9% return on YOUR money. Genius right! But that’s not the worst of it, let’s look at the example that made me write this post:
A new client came to me with an emergency fund of $15,000 in a savings account earning .15% with a certain bank. But then had a credit card with that same bank holding a balance of $5,000 with an A.P.R of 21.49%. Essentially, the bank was holding their money at .15% but then letting them borrow THEIR OWN MONEY back at 21.49%! The bank was literally making 20%+ interest on them alone. “Why are you paying to borrow your own money I asked?” After their blank stares, I explained the above and they were shocked that they didn’t realize what they were doing.
This is a simple concept but often isn’t put into perspective for many consumers. Paying to borrow your own money is not a savvy financial move and certainly won’t help you build wealth. So, how do we avoid letting the banks win? Well, we can’t stop them from making money off consumers but here are some tips to mitigate them making money off you:
Pay off your high-interest debt as fast as possible
Don’t borrow money if you have it
Put your emergency fund in a high-interest savings account. (See a great list here)
Don’t sit own more cash than you need. Build your emergency savings and invest the rest
All in all, giving banks business may seem like putting yourself in harm’s way, but of course, it still beats hiding your money under a mattress. If you understand how banks work, you’ll know where to look out for erroneous interest rates and how to avoid lining banks’ pockets by paying more interest than needed.