How Banks Make Money…
When you deposit money in an interest earning account at a bank, they pay you a small amount of money as interest on your deposit. If you have had a savings account at any time in the past several years, you know that the interest you get paid isn’t a lot. In the last 10 years the range has probably been from 1-5%, depending on the type of account and the bank.
Most banks have fees of various kinds associated with different accounts, which help to offset the operational costs of offering those accounts. Some of these fees have evolved into things like “overdraft lines of credit”, which amounts to an insanely expensive loan from the bank, and have turned into key profit generators for many banks. And this brings us to the real question:
Where does the bank make their money?
For every dollar that is sitting in checking accounts at any given bank, they probably have somewhere around $10 (or more) in outstanding LOANS.
It is through those loans that the bank makes their money.
It goes something like this:
You deposit a dollar, and get 1% interest on that dollar. That means you’ll get $.01 per year for that dollar.
The bank loans out that dollar, plus 9 more pretend dollars, and makes anywhere from 5%-29% interest on the $10 loan.
So while you’re making $0.01 per year on your dollar, the bank might be making over $2.00 per year on the money they loaned out (at a 20% interest rate.)
As you can see, if the bank is only paying you $0.01 per year for that dollar, and charging fees for using tellers and checks, you’re not getting much compared to what they are getting out of that same dollar.
In this (admittedly over-simplified) example, the bank makes somewhere around 200 times more than you do for every dollar you deposit.
And they make that money by issuing loans to consumers.
The higher the interest rate is on the loan, the more money the bank makes.
So while high interest rates on loans are “BAD” for you the consumer, they mean more money for the banks.
Of course, there is always the risk, especially with regards to unsecured debt, that a consumer won’t follow through with their obligation to pay back a loan.
The bank offsets those costs by doing three things:
1. Charging MORE for loans to consumers with a history of defaulting. More fees, more interest, more money.
2. Selling loans in default to bill collectors.
3. Getting a tax write off for losses on loans that go south.
To better understand how this works, let’s look at an example.
For the sake of this example, let’s say that a certain category of consumer (one with bad credit) gets higher interest rates because of past defaults. Let’s say, for the sake of illustration, that 30% of consumers in this category eventually default on a loan.
So out of 10 consumers with one $10,000 loan each (for a total of $100,000 in loans), 3 consumers will default on $30,000 worth of loans.
Let’s take those 10 consumers and look at what happens:
Each consumer pays roughly $100 per month in interest for the loans (at 20% interest). In addition to this, about $100 each month is going to principal.
Since 7 of the consumers will pay off the loan (in about 8 years), the bank will make around $75,000 off those 7 loans.
But what about the 3 consumers who don’t pay?
If they pay on their loans for an average of 2 years, the bank will make roughly $2,300 per consumer in that 2 years. Another $2,400 per consumer will have been paid towards the principal.
So the bank has an outstanding balance of $7,600 per consumer in default.
They then write that balance off, which reduces their taxes.
They then sell that $7,600 to a collection agency who pays $1,140 for the bad debt.
At this point, the bank has received…
$2,400 in principal payments
$2,300 in interest payments
$1,140 from the sell of the loan
(Not to mention the tax savings from the write off.)
That’s a total of $5,840 received on the 3 $10,000 loans, making it a total loss of $4,160 x 3, = $12,480.
Do you remember how much the bank made off the consumers who didn’t default?
Subtract the $12,480 losses from that number and their profit is somewhere around $62,000 on the “bad credit” loans.
These numbers are based on 10 loans at 20% interest with $200 per month payments, on which 3 of the 10 consumers eventually default.
What Good Credit Costs Banks
Let’s take the above example a step further. Let’s say that the 10 consumers that the bank loaned the money to were in a different category (those with good credit) that according to statistics, rarely defaults on loans.
So the 10 consumers would get their loans for $10,000 at perhaps 10% interest instead of 20%. With the same loan amount, and the same $200 per month payment, the 10 “good credit” consumers would only pay about $2,848 over the life of the loan.
The math here is simple:
$2,848 x 10 consumers = $28,480 profit on those 10 consumers.
Remember how much profit was in our “bad credit” example?
$62,000 was the rough estimate.
$62,000 – $28,480 = $33,520
And there is the answer:
Loaning $10,000 to 10 consumers with good credit versus 10 with bad credit could COST the bank $33,520.
Where The Money Is
We know that there are more numbers involved in the bank’s operations but we have given a simplified example here to illustrate this point:
The banks make more money on “higher risk” loans with higher interest rates.
And even at a 40% or 50% default rate, the numbers remain very attractive for the bank.
The real money is in high interest loans, or “sub-prime” loans.
The trick for the bank is getting consumers that are “risky” enough (or desperate enough) to pay higher interest rates, but reliable enough to keep the default rate within the limits needed to maintain profits.
And that’s where the credit bureaus come in…Part 2 Tomorrow…, “Credit Repair Conspiracy – Part 2” ( The Bureaus ).