When putting money in your bank account, have you ever wondered “what is your bank doing with your deposit?” Does it go in a vault somewhere, and someday, you can pull that exact dollar back out? Not exactly.

When a person deposits money into their bank account, the bank can then lend other people that money. The depositing customer gains a small amount of money in return (interest on deposits), and the lending customer pays a larger amount of money to the bank in return (interest on loans). To make money for itself, the bank keeps the difference.

It can be quite difficult to understand banking, since banks are complex and very different from most other businesses. Part of this is because it can be hard to understand what banks actually do, since they don’t make any physical products. In fact, a lot of people seem to think that banking is “free”, probably because banks keep advertising free checking accounts, free direct deposit, free budgeting features, etc.

So how do banks actually work, and what does any of that have to do with you? Here’s what you need to know.

The 3-6-3 rule

To fully understand how banks in the US make money, you need to understand a little about the history of US banking. Traditionally, banks made money by borrowing from depositors at low interest rates, lending that money at higher interest rates to borrowers, and pocketing the difference. Banking used to be heavily regulated, and the joke was that it was a 3-6-3 business; borrow money at 3%, lend it at 6%, and be at the golf course by 3 pm.

Most banks also charged a monthly fee to customers for maintaining a basic account. But, overall, service fees were low, constituting around 10% of total revenues.

The Impact of Deregulation

The wave of deregulation, beginning in the late 70s, changed this relationship. Main street companies discovered that they could borrow from the bond markets more cheaply than they could from banks, putting the “6” part of the 3-6-3 model under pressure.

And lots of new consumer products such as interest-bearing checking accounts, credit cards, money market accounts, home equity loans, student loans, etc. became available. Banking became a lot more complicated, so bankers couldn’t just head to the golf course at 3 pm anymore.

Two things ended up happening: banks realized that the bigger they were, the more loans they could make. With deregulation, the big banks grew even bigger by acquiring smaller banks. Banks also realized that an easy way to make more money was to simply charge consumers more fees.

How Banks Make Money

There are three main sources of revenue in retail banking today:

Net interest margin : This is the difference, or “net”, between the interest paid to depositors and the interest received from borrowers. At the moment (April 2020), the Fed’s low interest rate policy means that although depositors get almost no money for their savings, bank interest margins are also suffering as banks are unable to lend money out at a higher rate due to the low interest rate environment. Many large US banks are making margins around 3%, which, although on par with the 3% from the good old days of the 3-6-3 rule, constitutes much less revenue for banks as a result of deregulation and increased competition over the years.

: This is the difference, or “net”, between the interest paid to depositors and the interest received from borrowers. At the moment (April 2020), the Fed’s low interest rate policy means that although depositors get almost no money for their savings, bank interest margins are also suffering as banks are unable to lend money out at a higher rate due to the low interest rate environment. Many large US banks are making margins around 3%, which, although on par with the 3% from the good old days of the 3-6-3 rule, constitutes much less revenue for banks as a result of deregulation and increased competition over the years. Interchange : Every time you swipe a card at a store, the merchant pays a small percentage of the money to the bank that issued the card, called an interchange fee. For credit cards this is around 1.8%, while for debit cards it is nearer to 0.3%. Given that Americans spend more than they save, it is a huge revenue stream for banks.

: Every time you swipe a card at a store, the merchant pays a small percentage of the money to the bank that issued the card, called an interchange fee. For credit cards this is around 1.8%, while for debit cards it is nearer to 0.3%. Given that Americans spend more than they save, it is a huge revenue stream for banks. Fees: These are the fees that your bank charges you, including ATM fees, overdraft fees, late payment fees, penalty fees, etc.

Costs of Banking

There are a lot of costs associated with maintaining a bank. Maintaining security systems, marketing products, running ATM networks, and staffing call centers. However, all of those are dwarfed by the cost of maintaining physical branches, which account for the majority of bank’s costs.

Companies that offer online-only, or branchless banking (like Simple!), are able to maintain lower operating costs and spend their revenue in more customer-friendly ways.

The Bottom Line

After the economic banking crisis of 2008-2009, a handful of banks now dominate the market. At their scale, basic retail banking is immensely profitable—but are the big banks the best choice for the consumer? That depends.

When choosing a bank, you want to have a clear understanding of how the bank makes money and impacts you: Does it charge activation or monthly maintenance fees? Does it ding you for making too many withdrawals, or for transferring money from your savings to checking?

At Simple, we believe your money is your money, and you should be able to access it whenever you want. That’s why, Simple doesn’t charge hidden fees or allow overdrafts.

We make most of our money in two ways: the interest margin - the difference between the amount of interest made on loans, and the amount of interest paid to customers for balances. And, when you swipe your debit card, the merchant pays a service fee (called interchange) to the issuing bank.

That’s it. We only make money when our customers use and love their accounts.