(3) How banks make their money

Banks are businesses to whom we can 'give' money to keep it in a safe place. It is better to keep it in a bank than under the mattress. When we put our money into a bank account, it is the same as the bank borrowing money from us. The bank borrows money from many small savers like us. Other customers of the bank are people and businesses who have to borrow a lot of money, for example to buy a house, build a bridge or a motorway, etc. The bank collects all the money it has borrowed from us and lends it to the people who need a lot of money.

When we go to a tool-hire shop to hire (borrow) a hedge cutter or a lawnmower, or if we hire a car from a car hire company, or if we rent a house or a flat from a landlord, we have to pay some money to the tool hire shop, or to the car hire company, or to the landlord, for the benefits of using the tool, the car or the house or flat for a day, a week, or a year, etc. When we borrow something from a business (rather than a friend or relative), we have to pay for using that item. (This is still cheaper than buying it.)

The same applies to banks. When the bank borrows money from us, the bank pays us for the right to use our money. This payment of the bank to us is called 'interest'. If we lend the bank £100 for one year, at the end of the year the bank may give us back £105. The extra £5 is our interest, the interest the bank pays us for the money it has borrowed from us. Thus our money has worked for us. We have earned money without doing anything.

When the bank lends our money to its big customers, these customers have to pay interest to the bank for being allowed to use the bank's money for a time. If the bank lends our £100 to its big customers, it may charge £10 interest. When the big customer returns the money he has borrowed from the bank, he pays, say, £110 to the bank. He has borrowed £100, he repays £110.

The bank has earned £10 in interest. But that £10 is *** not *** profit. For, when you lent the bank your £100, the bank had to pay you £5. So the bank had to spend £5, and it earned £10. The difference between the £5 and £10, namely £5, is the bank's profit.

This is how banks make their money. They borrow small months of money from many small people, and pay them a small amount of interest. They put the money all together into a big sack (so to speak). Then they lend the money to someone who needs a lot of money and charge a high amount of interest for it. The difference between the interest which the bank charges and the interest which the bank has to pay to you and me, is the bank's profit. That's how banks make their money.

 

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(28 Jan 2008)

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