I am sure you realize that the bank pays you for keeping deposits there. Many young people do not have loans, so they have never thought out the process of banks making money. Why should they even care about keeping you as a customer? Here is how banks make money and a few ideas on making money in the same way.
To get the first questions out of the way, banks make a ton of money from different types of fees. NSF (overdraft) fees, low balance fees, transfer fees, wire fees, origination fees, and anything else that ends in “fee” is a hugely profitable area for most banks. NSF fees are one of the top money makers for the industry. Out of network ATM fees are pretty nice for them as well. Don’t pay them, negotiate them away or avoid them by knowing how your bank works.
Now, for the traditional bank money making technique. Banks borrow money at a lower rate than they lend it to someone else. I think it is a fairly simple process. Here is an example: Bank borrows $1,000 (from five people’s deposits) for 1% interest per year. Another customer decides to buy a $5,000 car and needs a loan. The bank loans that person the money at 6%. That gives the bank a 5% margin (6%-1%), or $250, in profit.
Banks do that a lot. That is the scale of “it takes money to make money.” If the bank has 1,000,000 customers with $1,000 and loans out 80% (assuming a 20% reserve requirement), they can earn $40 million in profit with a 5% spread. Even if 5% of the loan go bad, they still earn massive profits. The currently subsiding financial crisis was contributed to by a high number of loans becoming delinquent and forcing the banks to take large losses.
So, how can you make money like a bank? How can you borrow money at a low rate and loan it out at a higher rate? There are several options. Those include private loans, P2P lending, and gaming the no interest introductory rate system.
Private Loans: These are a good idea for wealthy individuals who have a high tolerance for risk. You can make an under-the-table loan to anyone with any terms that you see fit. Make sure to get a legal contract in writing so you can enforce your side, even for friends and family. There is a big risk that they may stop paying and you can’t do anything about it.
P2P Lending: I am a big fan of P2P lending if you have the right fit. P2P (Peer to Peer) lending cuts out the bank. You give the money, generally in $25 increments, to someone who needs a loan. You get the payments back for your share of the loan along with all interest. P2P lending facilitators, such as Lending Club and Prosper, take a small cut for being the middle man for the loan. If you diversify and loan money across many people, you are lowering your total portfolio risk. Lending Club has a detailed prospectus if you are interested.
Gaming the System: This takes a lot of time and effort, but you can make a little extra cash from gaming zero interest periods from credit cards and loan. Beware, however, that opening and closing credit cards has a big impact on your credit score. How does it work? If you see an introductory rate credit card with no interest and no fees, you can withdraw your entire credit line (hurts your credit score also) using a credit line check (sometimes has fees) and put the money into a high interest savings account or CD. Because you pay no interest, you keep the entire profit of the interest you earn from the CD or savings account. If you invest in other, higher returning places, such as stocks, you risk losing the initial investment and having to pay back the credit card loan at a loss or paying interest. I don’t recommend this, but some people do.
In all, it is tough to be the bank. The old adage “it takes money to make money” is true. There are big risks in playing banker, but there are big yields if it is done right. But if mafia loan sharks can do it, you can too. Just make sure things are legal, clean, and you are aware of any potential losses.
Have any of you tried these, or other, methods to earn interest from loans or the borrow/loan spread? Please let us know in the comments.