How do banks make money off of your money?

Author: Julia Rossabi

Editors: Amie Jin and Jerry Lin

What is “interest”, you may be asking? Well here is the answer to your question. In banking, people have the option to invest,r put their money into savings, or to take out loans.  Interest is the reward for saving and investing, or in other words, the cost when borrowing money.

When putting money into an interest-bearing account at a bank, you are essentially giving that money to thebank and they can use that money to temporarily loan it to others. In return,you will receive an interest rate from your bank, which means they deposit a certain amount of money into your account for the time that you keep your money there.

When you are the one taking out the loan, you are charged an interest rate for however long it takes you to pay the full amount. The amount of interest is calculated as a percentage of the principal, the amount borrowed. Let's say you figured out a payment plan with your bank to pay back this amount, usually through monthly payments. You pay both the principal and the interest, but at the beginning, a larger portion of your payment typically goes toward interest. As you continue making payments, the portion going toward interest decreases, while the portion going toward principal increases. 

There are three main types of interest. The first is simple interest. This loan type is based solely on the original principal borrowed, which is how interest is calculated. It is usually used for short-term financing, such as personal and student loans, because it often results in lower total interest payments. As you pay the daily interest, it decreases, making it easier to eliminate the interest if you complete extra payments. The formula to calculate the simple interest rate is:

“Principal x Rate x Time.”

Many people use this type of interest because it is easy to understand and the loan payments are predictable.

The second type of interest is compound interest. If you take out a loan, the lender charges you interest not only on the money you originally borrowed, but also on the interest that you accumulate over time. Each calculation of interest includes the principal amount along with the previously added interest. For example, if you owe $1,000 at 10% interest and make no payments are made, after one year you will owe $1,100 ($100 in interest). Then the next year, the 10% interest rate is calculated on the new total of $1,100, meaning you will now owe $1,210. This process will continue until you pay back the full amount you took out. As you can see, compound interest can grow quickly over time,which is why it is not always the preferred option for first-time borrowers

Lastly, there is accrued interest, which is the interest that has accumulated on the loan you have not yet paid. This interest grows daily or sometimes monthly dependingon the amount originally borrowed, the interest rate, and the amount of time that has passed. For example, if you take a loan of $1,000 with interest rate of 10% per year. To calculate your daily payment, you would first multiply $1000 x 0.10 = $100 per year then divide it by 365 (The amount of days in a year); 100/365≈0.27, which leaves you with approximately $0.27 per day. This means about $0.27 in interest is added daily. Now, let's say you would like to see how much you owe after 60 days. You would calculate $0.27 x 60 = $16.20. Adding this to your principal of $1,000 means you would owe $1,016.20. If it is not paid, the amount will continue to increase. Similar to compound interest, this can become unmanageable and grow to a point where you are not able to repay the amount.

Banks profit from this system by charging borrowers higher interest rates than they pay depositors. For example, if I deposited $100 into a bank and earned 5% interest over five years, the bank pays me based on that rate. However, if I were to take out a loan of $100, the bank might charge me an interest rate of 7%. The difference between what they pay depositors and what they charge borrowers is how banks make a profit.

---

Sources

1. https://www.pnc.com/insights/personal-finance/save/what-is-interest-and-how-does-it-work-.html

2. https://www.citizensbank.com/learning/do-checking-accounts-earn-interest.aspx

3. https://www.rocketmortgage.com/learn/principal-and-interest

4. https://www.pnc.com/insights/personal-finance/save/what-is-compound-interest.html#:~:text=Compound%20interest%20is%20interest%20calculated,plus%20any%20previously%20accumulated%20interest.

5. https://www.capitalone.com/learn-grow/money-management/simple-interest-vs-compound-interest/

6. https://www.purduefed.com/Resources/Education/Purdue-FCU-Blog/June-2024/How-Does-Amortization-Work#:~:text=The%20Basics%20of%20Amortization&text=Each%20payment%20funnels%20money%20to,other%20loan%20terms%20impact%20amortization.