How do banks profit from savings accounts?
Ever wonder why a bank pays you interest for the money in your savings account? After all, you didn’t do anything besides put the money in the account. The interest is free money awarded with no effort required on your part. Why do they do it? And perhaps more importantly, how can a bank afford to pay interest?
Before answering the why’s and how’s of savings accounts, it’s important to understand how banks make money. Having a strong base of savings account deposits is critical for a bank to remain solvent and profitable. Banks use that money to lend to borrowers, who then pay interest on their loans. After paying for various costs, banks pay money on savings deposits to attract new savers and keep the ones they have.
The difference between the money earned as interest on loans, any operating expenses, and the money paid as interest to savings accounts is profit to the banks. For example, assume you deposit £1,000 into a savings account that pays 1% interest. Your interest payment for the year is £10.
Now, assume that the bank loans your £1,000 to a business at a 5% interest rate. The bank will earn £50 in interest income. Now assume that the bank has £30 worth of expenses to pay for employees, property, insurance and other expenses. That leaves £20. They don’t pay the full amount as interest to savers because they need to keep some as a profit. That may mean £10 in interest to you and £10 in profit to the bank.
Banks will raise or lower their interest rates on savings accounts based on a few factors. One is the amount of interest they’ve been able to charge borrowers. Another factor is the prime interest rate in the country in which the bank is based. Finally, the third factor is how aggressive the bank would like to be in pursuing new account holders. If the bank would like to lend more, they may raise their interest rates on savings accounts to attract a larger base of deposits.
How safe are banks?
The question many have is whether their accounts are safe. After all, what if the bank lends the money and the borrower never pays it back? Couldn’t your money be gone forever?
Probably not. Banks, especially large ones, diversify their risk by lending to millions of borrowers. There will always be some borrowers who don’t pay in a timely manner. However, the bank will try to reduce this risk by carefully analysing each loan application.
Some countries also have governmental regulations to protect savers should a bank go out of business. In the U.K., up to £85,000 is protected per eligible person and per bank. So if a person had multiple accounts at multiple banks, each banking relationship would be protected up to that level. Temporary high balances up to £1m and up to 6 months can also qualify for protection. European Union countries offer a €100,000 level of protection per customer and per banking relationship.
Banks can and do compete with each other to attract new savers. It’s worthwhile to regularly check interest rates at competing banks. You may find a bank that is aggressive in its pursuit of new customers and is willing to pay a higher-than-average rate.
A financial adviser who is familiar with banking systems around the world could also help you find a bank that offers a competitive interest rate and provides an appropriate amount of security and protection. Your financial adviser can work with you to not only select the best and most suitable banks, but we’re also well-placed to explore all the other available options to safeguard, grow and maximise savings beyond the, typically, low-interest bearing bank accounts.
About Mike Coady
Mike Coady is an expat expert based in Dubai and is on hand to help with all of the above and more.
Mike is an award-winning money coach and industry leader in the financial sector.
Qualified to UK Financial Conduct Authority (FCA) standards, a member of the Chartered Insurance Institute, a Fellow of the Institute of Sales Management (FISM), a Fellow of the Institute of Directors (FIoD) and featured as a highly qualified Financial Adviser in Which Financial Adviser.
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Blog published by Mike Coady.