How Banks Make Money

The following is a transcript of "Money Girl's Quick and Dirty Tips for a Richer Life," a podcast from QuickAndDirtyTips.com. The audio program is available via RSS feed here and at TheStreet.com's podcast home page.

Hello and welcome to Money Girl's Quick and Dirty Tips for a Richer Life.

In today's episode, I want to talk about how banks work.

How Banks Make Money

Banks make money by making loans. Depositors put money into the bank and the bank turns around and lends the money out to a borrower. The interest rate the bank charges a borrower is higher than the interest rate it pays on deposits. Banks make money off this difference, which is called the "spread."

Banks Lend Many Times More Than They Have

But that's just the beginning. The amount of money that a bank can lend is actually much, much greater than the deposits in the bank. Banks lend out many times more money than they actually have. How much they can lend out depends on the reserve requirement set by the Federal Reserve.

In the United States, reserve requirements are typically 10% of the total value of the checking accounts at the bank. A small reserve requirement magnifies the amount of money banks make from lending money.

Think about it this way: If your bank has a 10% reserve requirement and you deposit $1000 in your checking account, the bank must keep 10% or $100, but it's free to lend out $900 at interest. The person who borrows that $900 will spend it and it will usually be deposited into another bank. Then that bank will do the same thing. It will keep 10% or $90 and then it's free to lend out the rest at interest, which is $900 minus the $90, or $810. This process is repeated again and again, and is called "fractional reserve banking." Each time the bank receives a deposit, it keeps 10% as reserves and can lend out the rest at interest.