How Banks use the Money you Deposit to Make Loans

You deposit your money in the bank. Where does it go? Is it stored in a big vault in the basement of the bank waiting for you to withdraw it? Keep reading to learn the answer.

Banking is a business. Just like other businesses the goal is to earn money.

When you deposit money in a bank, you are lending it. It still belongs to you, but banks make use of your money to earn money. Some of the money is kept by banks, but most of the deposited money is used to make loans. Banks then make money from the interest charged on those loans. The banks make a profit by earning more from the money they lend to others than they pay to provide services and interest to you.

Banks “pay” you in several ways. First, they provide services in return for your money. For example, banks handle financial transactions. Without this service, you would have to physically go to all the places you do business with and pay your bills in person. Second, on certain kinds of accounts you receive money in the form of interest. Finally, people consider banks a safe place to keep their money.

Thus, banks earn money by loaning out the money you deposit. They are required to hold on to enough money for depositors to withdraw. The Federal Reserve Bank sets a reserve requirement, which is the amount of money banks must keep on hand. This requirement is somewhere between 3 percent and 10 percent.

Some types of bank accounts require depositors to leave their money in the account for a pre-defined amount of time. There are other accounts which require a minimum balance. Depositors receive a higher amount of interest on these accounts because banks are assured that most of those funds will not be withdrawn within the time specified.

People who make deposits in banks need to trust that their money is safe. The Federal Deposit Insurance Company guarantees to pay depositors up to $250,000.  This limit will be in effect until December 31, 2013, at which point it will be reduced to $100,000.  The FDIC website has additional information about depositor insurance,

The loans that are made by banks are essential to the economy. Without loans most people wouldn’t be able to buy houses and cars, start businesses or pay for college.

The system functions when everyone trusts that it works, and when everyone behaves in a relatively consistent manner. Banks keep enough money on hand to be able to comfortably cover the expected amount of withdrawals. On the other hand, banks trust that most of the loans they make will be paid back with interest.

There are many more complexities involved in banking. The information provided her is intended to give a basic understanding of how the system works.