Banks lend out most of the money you deposit, and keep the difference between what they pay you and what borrowers pay them

When you put money in a savings account, the bank does not lock it in a vault with your name on it. Instead, the bank uses your deposit to lend to other customers — for mortgages, car loans, credit cards, and business lines of credit. You earn interest on your deposit (usually a small percentage each year). Borrowers pay the bank a higher interest rate on their loans. The bank keeps the spread between these two rates as income.

This is the primary way banks generate revenue. A bank might pay you 0.5% annual interest on a savings account, then lend that same money to a homebuyer at 7% interest on a mortgage. The bank pockets roughly 6.5% as profit — minus the costs of running the bank itself.

Banks are required by law to keep a portion of deposits on hand (called a reserve requirement) and cannot lend out every dollar you deposit. The exact percentage varies by account type and is set by the Federal Reserve, but it is typically a small fraction of total deposits. This ensures banks can always return your money if you withdraw it.

Key Takeaways

  • Banks earn money primarily by lending deposits to borrowers at a higher interest rate than they pay depositors.
  • The difference between the interest rate paid to depositors and the rate charged to borrowers is called the spread, and this is the bank's main profit source.
  • Banks must keep a percentage of deposits in reserve and cannot lend out all customer funds.
  • Banks also earn income from fees on accounts, overdrafts, wire transfers, and other services.
  • The interest rates banks offer on deposits are typically much lower than the rates they charge borrowers because of this lending business model.

The interest rate spread: where most bank profit comes from

The spread is the gap between what a bank pays depositors and what it charges borrowers. This is the engine of bank profitability. If a bank pays 1% interest on a money market account and lends that money at 6% on a personal loan, the spread is 5%. Multiply that 5% by millions of dollars in deposits, and the result is substantial revenue.

The size of the spread depends on several factors. When the Federal Reserve raises interest rates, banks can charge borrowers more, which widens the spread. When rates fall, the spread narrows because banks cannot lower deposit rates below zero, but they may have to lower loan rates to stay competitive. Economic conditions also matter: during recessions, banks charge higher rates to compensate for increased risk that borrowers will default.

Different types of loans carry different spreads. Mortgages typically have smaller spreads (maybe 2% to 3%) because they are secured by the house itself, making them lower risk. Credit card loans have much larger spreads (often 15% or more) because they are unsecured and carry higher default risk. A bank's overall profit depends on the mix of loans it holds.

How reserve requirements limit how much banks can lend

The Federal Reserve requires banks to hold a minimum percentage of deposits in reserve — money that cannot be lent out. This reserve sits in the bank's vault or in an account at the Federal Reserve itself. The purpose is to may support the bank can meet withdrawal requests even during a financial crisis.

For most deposit accounts, the reserve requirement is currently 0% — the Federal Reserve suspended it in 2020 and has not reinstated it. However, banks still hold reserves voluntarily because regulators expect it and because it is prudent risk management. A bank that lends out every dollar it receives has no cushion if many customers withdraw money at once.

Even without a legal requirement, banks cannot lend out all deposits because deposits are liabilities — the bank owes that money to you. The bank's own capital (the money the bank's owners have invested) is what absorbs losses if loans go bad. Regulators require banks to maintain a certain ratio of capital to loans, which limits how aggressively a bank can lend.

Fees and other sources of bank income

Interest on loans is not the only way banks make money. Banks also charge fees for services. These include monthly account maintenance fees, overdraft fees (charged when you spend more than your balance), wire transfer fees, ATM fees at other banks' machines, and fees for stopping a check payment.

Some banks charge fees for opening accounts, closing accounts early, or falling below a minimum balance. Credit card companies (often owned by banks) earn fees from merchants every time you swipe the card — typically 2% to 3% of the transaction. Banks also earn fees from investment services, wealth management, and insurance products they sell to customers.

During periods of high interest rates, the spread on deposits is wide enough that many banks reduce or eliminate fees to attract customers. During periods of low rates, banks rely more heavily on fees to maintain profitability. The mix of income sources varies by bank size and strategy.

Why deposit interest rates are so much lower than loan rates

You may notice that the interest rate your bank offers on savings is far lower than the rate you would pay on a loan. This is not a mistake or unfair pricing — it reflects the bank's business model. The bank needs a large spread to cover operating costs, pay employees, maintain branches, invest in technology, and absorb losses from loans that default.

A typical bank's operating costs run 50% to 60% of its revenue. This includes salaries, rent, utilities, insurance, and regulatory compliance. If a bank paid depositors 4% interest and charged borrowers 5%, the 1% spread would not cover these costs. The bank would lose money.

Banks also must set aside capital for unexpected losses. If a bank makes 100 loans and 5 of them default, the bank loses the principal on those 5 loans. The spread on all other loans must be large enough to cover this expected loss rate. Riskier lending (like credit cards) requires a larger spread to account for higher default rates.

How economic conditions affect bank income

When the Federal Reserve raises interest rates, banks benefit in the short term. They can charge borrowers higher rates when ready, but they do not have to raise rates on existing deposits right away. This widens the spread and increases profit. However, as time passes and deposits mature or customers move money to higher-paying accounts, banks must raise deposit rates to stay competitive, which narrows the spread again.

When interest rates fall, the opposite happens. Banks must lower loan rates to stay competitive with other lenders, but they cannot lower deposit rates below zero. This squeezes the spread and reduces profitability. During the period from 2008 to 2021, when interest rates were very low, many banks struggled with narrow spreads and relied more heavily on fees and other income sources.

Economic recessions also affect bank income through loan defaults. When unemployment rises, borrowers are more likely to miss payments or default entirely. Banks must set aside more capital to cover expected losses, which reduces the profit they can distribute to shareholders. This is why bank profits tend to fall during recessions even if the spread remains wide.

The relationship between deposits and bank stability

Deposits are crucial to a bank's stability because they are a cheap source of funding. A bank could borrow money from other banks or from investors, but deposits are usually cheaper because depositors accept lower interest rates in exchange for safety and convenience. A bank with a large deposit base can lend more and generate more income than a bank that relies on borrowed funds.

However, deposits also create risk. If many customers lose confidence in a bank and withdraw their deposits at once (called a bank run), the bank may not have enough cash on hand to pay everyone. This is why the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per account holder per bank. This insurance protects depositors and prevents bank runs by guaranteeing that money will be returned even if the bank fails.

Banks manage deposit risk by diversifying their funding sources and maintaining adequate reserves. They also monitor how much of their deposits are in accounts that could be withdrawn quickly (like checking accounts) versus accounts with longer time horizons (like certificates of deposit). A bank with too many short-term deposits faces higher risk if customers withdraw money unexpectedly.

Frequently Asked Questions

If my bank pays me 0.5% interest but charges borrowers 7%, where does the other 6.5% go?

The bank keeps roughly 6.5% as gross profit, but this is not all net profit. The bank must pay employees, maintain buildings and technology, buy insurance, comply with regulations, and set aside capital for loan losses. After all these costs, the actual profit margin is typically 15% to 25% of the spread.

What happens to my money if the bank lends it out and the borrower does not pay back?

Your deposit is protected by FDIC insurance up to $250,000, regardless of whether the borrower repays. If the bank fails, the FDIC covers your loss. The bank absorbs the loss on the bad loan through its own capital reserves.

Do all banks use the same interest rates for deposits and loans?

No. Interest rates vary by bank, by account type, and by loan type. Online banks often pay higher deposit rates because they have lower operating costs. Credit unions typically offer better rates to members because they are not-for-profit. Loan rates depend on the borrower's credit score, the loan term, and current market conditions.

Can a bank run out of money to lend?

A bank can run out of available funds to lend if deposits decline or if regulators require it to hold more capital. During the 2008 financial crisis, many banks stopped lending because they were uncertain about losses and wanted to preserve capital. Banks can also choose not to lend if they believe the economic outlook is too risky.

Why do some banks offer higher interest rates on savings than others?

Banks with lower operating costs (like online banks) can afford to pay higher deposit rates and still maintain profitability. Banks facing deposit shortages may raise rates to attract more customers. Banks in highly competitive markets may offer better rates to stand out. Economic conditions and the bank's overall strategy also play a role.