What happens to a $10 bill after you deposit it in your savings account? Does the
bank teller take it to a vault and put it into a separate compartment or cubbyhole
marked with your name and account number? No.
The bank begins by adding $10 to the amount that is already in your account (your
existing balance). Your $10 deposit and your new balance are then recorded in your
bank book and in the bank’s computer system. The $10 bill you deposited is mixed in
with all the other cash your bank receives that day.
When you and other customers deposit money in a bank, the bank “puts most of it to
work.” Part of the money is set aside and held in reserve, but much of the rest is
loaned to people who need to borrow money in order to buy a house or a car, expand a
business, buy farm equipment, or do any of the other things that require people to
borrow money. Of course, banks do not lend money just to provide a service. They do
it to make money. Here’s how it works.
When you keep your savings in a bank, the bank pays you extra money, which is called
interest. The interest is added to your account on a regular basis, usually once a
month.
Let’s say a bank pays its depositors interest of 3 percent a year on their savings.
In simple terms, that means if you keep $100 in your savings account, the bank will
add $3 to your account balance during the course of a year.
But, there is another side to interest. When someone borrows money from a bank, the
bank charges interest, and it charges borrowers a higher rate than it pays savers.
For example, it might pay savers 3 percent and charge borrowers 8 percent. The
difference, 8 percent minus 3 percent, goes to the bank. Charging interest on loans
is one of the main ways for a bank to make money.
The rate of interest a bank charges depends largely on two things:
• how many people want to borrow money, and
• how much money banks have available to lend.
If a bank has plenty of money to lend, and the demand to borrow money is not
particularly strong, interest rates will tend to be low in order to attract
borrowers. But when banks have a smaller amount of money to lend, and the demand to
borrow is fairly strong, interest rates will rise. As a depositor, you want interest
rates to be high, but as a borrower, you want them
to be low. When it comes to paying interest on savings deposits, there usually isn’t
a big difference between banks. They pay just enough to stay competitive with one
another and attract depositors. So, if one bank is offering a much better (higher)
rate than most other banks, try to find out why. And remember the old saying: If
something sounds too good to be true, it
probably is.
