If you’ve ever applied for a bank loan, have you ever wondered where the bank gets its money from? How do banks actually make money so that they can lend to so many borrowers?
To be able to lend money to borrowers, banks must first be able to make money. They do this by taking in deposits from depositors, offering them an interest. This money is what they lend out to borrowers, charging them a higher interest rate. They also make money from other services that they offer.
Read on to learn more about where banks get the money they lend, types of loans, and what banks check to approve loans.
Where Do Banks Get Money To Lend To Borrowers?
Banks are financial institutions that open their doors to the public for transactions on cash and credit. People trust banks to keep their money safely. They have a variety of accounts that you can choose from, like savings accounts and checking accounts.
Banks also let you apply for many kinds of loans like:
- Home mortgages,
- Car loans,
- Business loans, and
- Personal loans.
They are a huge contributor to the economy of a country. So, where exactly do they get the money that they lend out to the borrowers?
To be able to lend money to borrowers, a bank must first generate the money. They do this by getting deposits from their clients, giving them an interest rate. This money is what they lend out to borrowers, charging them a higher interest rate. They also generate money from other services they offer, such as investment banking.
How Do Banks Generate Money?
Banks generate money basically in three ways. They are:
- Capital markets
- Fee-based income
Lets’s take a closer look at each one:
Banks primarily generate money from interest income. When depositors bring in their money to the bank to deposit, they are given a certain interest rate for their money.
The bank then lends the money from the depositors to borrowers with an interest rate higher than what they give the depositors. The bank makes an income from the interest spread – this is what is left from the interest they pay and the interest they receive.
The income coming from the interest rates charged on loans is a major driver of revenue. The central bank sets the rates for interest to help control inflation and to boost the economy.
2. Capital Markets
Most banks will offer various capital market services for investors and corporations. These services include:
- Sales and trading services,
- Underwriting services, and
- M&A advisory.
A lot of banks have their own brokerage services and can greatly help their clients with trading.
These banks can also assist with underwriting debt and equity because they have staff dedicated to investment banking.
Mergers and acquisitions (M&A) also generate money for banks because they charge a certain amount as fees when their M&A team assists clients with these deals. However, the capital markets income for banks is not the main source of income because this fluctuates.
3. Fee-based Income
Banks often charge other fees for their services as a way to generate income. Some of these charges are credit card fees, monthly fees for savings and checking accounts, mutual fund revenue, custodian fee, and fees for investment management.
The bank also assists clients in wealth management, and they get a fee from doing so. There are also fees for mutual fund services. This type of income for the bank does not fluctuate and is a stable source for generating money.
Types of Loans Borrowers Can Get From a Bank
The bank gives borrowers many options if they want to loan money. As we just discussed above, banks generally make money from the following:
- Capital market income, and
- Fee-based income.
The banks use their profit and money from other depositors to loan borrowers with a higher interest rate.
The following are the different loans you can get from the bank:
1. Personal Loans
Clients apply for personal loans for many reasons. They can be used for the following:
- Home renovations,
- Celebrations such as weddings,
- Travel costs,
- Relocating to a new city, and many other reasons.
Personal loans can have a payment scheme of 24 to 84 months, depending on the amount.
There are two kinds of personal loans:
- Secured Personal Loan
- Unsecured Personal Loan
Secured loans require that you have collateral like a vehicle or automatic debiting from a savings account monthly. This assures the back that if you can’t pay the loan, they can take something back.
Unsecured loans are also called signature loans. They require no collateral and only need your signature. To be able to acquire an unsecured loan, you need to have a good credit standing. This kind of loan usually has a high-interest rate.
2. Student Loans
Student loans are for paying tuition fees and other fees related to education. There are two types of student loans:
- Federal Loan
- Private Loan
Federal Student Loan
Federal student loans require you to work with your school to apply for the loan. They usually have higher interest rates than personal student loans.
Private Student Loan
Private student loans are loans that you can apply for if you have good credit standing.
3. Auto Loans
Auto loans are used for purchasing vehicles, and they can be paid with a scheme of anywhere from three to seven years. The bank will require that the vehicle be the collateral for the loan, and if you are unable to pay the loan, they will repossess the vehicle.
4. Mortgage Loans
Mortgage loans are there to help you purchase your home. These loans have a long-term paying scheme. They can be anywhere from ten to 30 years.
5. Home Equity Loans
This is commonly referred to as a second mortgage. To be able to avail of this loan, you need to have equity in your home. Whatever percentage you own in your home, let’s say, for example, you have 70% equity. That portion can be used to secure a loan. Most banks will let you take out a loan of up to 85% of your home. This loan can be payable anywhere from 5 to 25 years.
6. Credit Builder Loans
Credit builder loans are loans that help you establish your credit. Often, these loans are small and are payable in the short term. If it’s your first time applying for a loan, this is a good and safe way to start building credit.
This kind of loan works differently. What happens is, you are asked to make fixed monthly payments, and you receive the money at the end of the term. It works well if you have an auto-pay system so that you never forget a payment. Annual rates for these loans are 6% – 16%.
7. Debt Consolidation Loans
This loan pays off all your debts from other creditors so that you only need to worry about one monthly payment.
If your credit card interest is high and you have multiple debts on various credit cards, getting a debt consolidation loan can be helpful because the debt consolidation loan interest rate may be lower. Check out the rates that your bank offers for debt consolidation loans to see if it is lower.
8. Payday Loans
Payday loans are small loans and are short-term just so that you can last until your next paycheck. You won’t need an established credit line to avail of this loan. However, always check the interest rate because payday loans normally have a huge interest rate.
9. Small Business Loans
You can apply for a loan to start a small business or build up an existing small business. You’ll be asked to present papers of your small business for loan approval. The loan can run anywhere from three to eight years.
Again, where do banks get money to lend borrowers? A certain interest rate entices depositors to deposit their money in a bank. Banks then use this deposit to lend to borrowers, which they charge with a higher interest rate. Their profit comes from the interest rate spread.
What Does the Bank Look at Before Lending to Borrowers
We already know where banks get money so that they can lend to borrowers. Now, let’s look at what they will check before approving a loan to a borrower:
1. Your Credit Score
Your credit score says a lot about how you manage your finances. A bank will not lend to someone with a poor credit score because of the risk of not getting paid. The higher your credit score, the easier it is to secure a loan. If you have a low credit score, the bank will verify and check why you have a low credit score.
2. Your Income
The bank will check your income as a basis of capacity to pay. They will also check your employment history to see if you are capable of maintaining a consistent income. If you’re taking out a big loan, you’ll need to have a higher income, so the bank feels confident that the loan won’t go into default.
3. Debt-to-income Ratio
This is another important thing that banks will check before approving a loan. The debt-to-income ratio is your debt obligations in relative comparison to your income. A good percentage here is less than 40% to be approved for a loan.
4. Collateral Value
Collateral is something of value that you agree to hand over to the lender if you default on your loan. The bank will not lend more than the actual value of your collateral. For example, for auto loans, the collateral is the vehicle itself, so the loan amount cannot be higher than the vehicle’s value.
5. Liquid Assets
The lender will check how many liquid assets you have available such as a savings account or money market account. Liquid assets assure the lender that you can still pay if you lose your income as the capacity to pay because you have these assets. Having substantial liquid assets may also lower your interest rate for the loan.
6. Loan Term
How many years do you plan to pay off the loan? Lenders will check your capacity to pay, and even though your financial situation may be good now, who knows how it will be in five or ten years. If you’re applying for a loan for a shorter period of time, chances are better for getting loan approval.
A shorter loan term means that you will be paying an interest rate for a shorter period of time, but that means that you will have higher monthly amortizations. You’ll need to assess the best loan term for your situation.
These factors are what lenders check before they approve your loan. Before you apply for a loan, it is best to assess your financial situation to have a better chance of getting approved as a borrower.
Conclusion: Where Do Banks Get Money to Lend to Borrowers
Banks are known to be lenders of different types of loans. With so many people borrowing from banks, how exactly can banks lend? Where do they get money to lend borrowers?
To be able to lend money to borrowers, banks need to generate the money. They do this by taking in deposits from their clients offering an interest rate. This money is what they lend out to borrowers, charging them a higher interest rate.
They also make money from other services. Banks make a profit from the following too – interest income, capital market income, and fee-based income.