How do banks make money? Let’s make this very simple by pretending that you own a hardware store, and your job today is to sell hammers. Hammers cost $10 at your store, but you have to buy them first at $7. That’s what it costs to forge them, put them together, ship them to your store, and put them on the shelves. It cost you $7. If you charge your customers $10, what did you make for each hammer? Well, you would think it’s the difference of $10 – $7, that would be $3 that you made after spending $7, right?
But what’s your spread? Was it worth it to sell the hammer at $10? Did you make enough money as far as a percentage if you think about your store as an investment? I’m going to do the math a different way using a regular calculator here to show you how to calculate the spread:
10 ÷ 7 = 1.4285
1.4285 - 1 = .4285
.4285 * 100= 42.85%
Is that really the amount of money that I earned? 42.85%? Well, let’s look at it another way to double-check.
$7 * 42.85% = $3
7 + 3 = 10
Son of a gun. There’s my 10. So, I made 42.85% on the sale of a simple hammer. Well, if it works that way for your hardware store, what about the bank? First of all, what do they sell? They don’t sell anything that has to be created. They sell money. Where did they get the money from? They actually get the money from you. So, they rent your money They’re given your money when you put it into the bank. The bank turns around and rents your money to someone else.
If you were to go to any regular bank (and I just checked online to see what some of the rates are right now) and if you were to purchase a long-term certificate of deposit, the current rate is 5.15% for a 13-month CD. To make this easier, let’s just call it 5%. So, I can give my money to the bank, they’re going to give me 5%, but then they’re also going to turn around and rent it to someone else who needs it. Let’s say my money is then used for an automobile loan to someone else. For that same bank, a 72-month auto loan is at 6.99%. Again, let’s just make it simple and just call that 7%. Some people may think they only made 2%, the difference between 7% and 5% is 2%, right? Remember in the first calculation we first did subtraction, but to find the rate of return or the cost, the spread, you have to do some multiplication and division. It’s a different calculation:
7 ÷ 5 = 1.4
1.4 – 1 = .4
.4 * 100 = 40%
Let’s double-check again to see if my math works. Remember, I was given a CD of 5% with my bank.
5 * 40% = 2
5 + 2 = 7
Son of a gun. There’s my 7%. That is a 40% spread. In this example, the bank made a gross profit of 40% on my money. They paid me 5% on a CD in order to get my money and put it into their bank to rent my money to someone else and make 40% off of that money.
But think about this: How many people don’t have certificates of deposit? They usually just have a regular savings account. Let’s say that they are earning a very generous 1% on their savings account. The bank takes their money and then charges 7% on the automobile loan.
7 ÷ 1 = 7
That’s is 700%. How can the bank be making 700%? That has got to be wrong. The wonderful thing about math is that we can double-check it both ways and if the numbers work, the numbers are correct. Let’s take a look at the gross margin. If I have 1% earnings in my savings account and I multiply it by seven hundred percent, that’s 7%, which is what they are charging the person with an automobile loan for money that they’re renting from me for just 1%, see below:
1 * 700% = 7
If how banks make money is a brand-new concept for you, just think about how money works in other ways that you don’t know. If you didn’t know how money works and you had the opportunity to learn from us, how long would it take for you to sit down with us and find out exactly how money works in the real world? If you’re interested, then perhaps it’s time to schedule your Financialoscopy®.