What banks do with your money

When you deposit money into a bank account, the bank does not lock it in a vault with your name on it. Instead, the bank lends most of that money to other customers — for mortgages, car loans, credit cards, and business loans. The bank keeps a small portion in reserve (required by federal law) and uses the difference between what it pays you in interest and what it charges borrowers in interest as its profit.

This is how banks make money. They are not storing your cash; they are using it as capital to lend. When you withdraw money, the bank pulls from its reserves or from new deposits coming in that day. As long as not everyone withdraws at once, the system works. If a bank runs out of reserves and cannot cover withdrawals, the Federal Deposit Insurance Corporation (FDIC) steps in — up to $250,000 per account holder per bank.

Key Takeaways

  • Banks lend out most customer deposits to borrowers and keep the difference between deposit interest rates and loan interest rates as profit.
  • The Federal Reserve sets the discount rate, which influences how much banks charge each other to borrow and what they pay you on savings.
  • Banks are required to hold a percentage of deposits in reserve, though the exact amount varies by account type and bank size.
  • The FDIC insures deposits up to $250,000 per account holder per bank, protecting your money if the bank fails.
  • Banks generate revenue from interest on loans, fees for services, and investment activities, not from storing your deposits.

How the Federal Reserve influences what banks pay and charge

The Federal Reserve (the central bank of the United States) does not run individual banks, but it sets the federal funds rate — the interest rate at which banks lend reserve balances to each other overnight. This rate filters down to affect almost everything else: the interest rate your bank offers on savings accounts, the rate it charges on mortgages, and the rate it charges on credit cards.

When the Federal Reserve raises its rate, banks pay more to borrow from each other, so they raise the rates they charge borrowers and lower the rates they pay depositors. When the Federal Reserve lowers its rate, the opposite happens. This is why your savings account interest rate changes even though you did nothing — the bank is responding to signals from the Federal Reserve.

The Federal Reserve also requires banks to hold a minimum percentage of customer deposits in reserve. This reserve requirement varies by the size of the bank and the type of account. The requirement exists to ensure banks can cover withdrawals and to give regulators a tool to control how much money is circulating in the economy.

Where banks get money to lend

Banks fund loans through three main sources: customer deposits, borrowing from other banks or the Federal Reserve, and capital raised from investors (shareholders). Most of a bank's lending power comes from deposits — yours and everyone else's. A bank with $1 billion in deposits might lend out $900 million of it, keeping $100 million in reserve.

When a bank needs short-term cash, it borrows from other banks in the federal funds market or from the Federal Reserve's discount window. When a bank needs long-term capital to grow, it sells stock or bonds to investors. All three sources have different costs, and banks balance them to maximize profit while staying within regulatory requirements.

Banks also generate revenue from fees — overdraft fees, monthly account maintenance fees, wire transfer fees, ATM fees — and from investment activities like trading securities or managing investment portfolios for wealthy clients. For large banks, investment income can rival or exceed lending income.

How banks decide who gets a loan

Banks use a process called underwriting to decide whether to lend money and at what interest rate. An underwriter reviews your credit history (pulled from credit bureaus), your income (verified through tax returns or pay stubs), your existing debts, and the value of any collateral (like a house for a mortgage). The goal is to predict the probability that you will repay the loan.

Banks assign a credit score based on your payment history, amount of debt, length of credit history, and mix of credit types. A higher score means lower risk, so you get a lower interest rate. A lower score means higher risk, so you pay a higher rate — or the bank declines the loan entirely. This is why your credit score matters: it directly affects how much you pay to borrow.

For small business loans, the process is similar but also includes a review of the business's financial statements, cash flow, and the owner's personal credit. Banks are more cautious with business loans because businesses fail more often than individuals default on mortgages.

What happens when a bank fails

A bank fails when it runs out of money to cover customer withdrawals and cannot borrow more. This can happen if too many loans go unpaid, if the bank makes bad investment decisions, or if depositors lose confidence and withdraw money faster than the bank can cover (called a bank run).

When a bank fails, the FDIC takes over. It pays out deposits up to $250,000 per account holder per bank from an insurance fund. If you have $300,000 in one account at one bank, $250,000 is covered and $50,000 is not. If you have $250,000 at Bank A and $250,000 at Bank B, both are fully covered because the FDIC insures per bank, not per person.

The FDIC then sells the failed bank's assets (loans, real estate, securities) to recover money for the insurance fund. Customers usually regain access to their insured deposits within a few days. The last major bank failure in the United States was Washington Mutual in 2008 during the financial crisis.

The difference between commercial banks and other financial institutions

A commercial bank takes deposits and makes loans to individuals and businesses. A savings bank or credit union does the same thing but is structured differently — credit unions are member-owned cooperatives, not shareholder-owned corporations. A brokerage buys and sells securities (stocks, bonds) but does not take deposits or make traditional loans. An investment bank helps corporations raise money and advises on mergers; it does not take deposits from regular customers.

All of these institutions are regulated, but by different agencies and under different rules. Commercial banks are regulated by the Federal Reserve, the FDIC, and the Comptroller of the Currency. Credit unions are regulated by the National Credit Union Administration. Brokerages are regulated by the Securities and Exchange Commission. These different regulatory structures mean different rules about what they can do with your money and how much they must hold in reserve.

How interest rates on your accounts are set

The interest rate your bank pays on a savings account or money market account is set by the bank based on three things: the Federal Reserve's rate, what competing banks are offering, and how much the bank needs deposits right now. If the Federal Reserve raises its rate and competing banks raise their savings rates, your bank will likely raise yours too — otherwise you might move your money elsewhere.

Banks also offer different rates for different account types. A high-yield savings account pays more than a regular savings account because the bank is trying to attract larger deposits or longer-term commitments. A certificate of deposit (CD) pays more than a savings account because you agree to lock your money away for a set period (three months, one year, five years). The longer the lock-in period, the higher the rate, because the bank knows it can lend that money out for longer.

Checking accounts typically pay little or no interest because the bank expects you to withdraw money frequently, making it harder to lend out. The bank makes money on checking accounts through fees and by lending out the small portion of deposits it can predict will stay in the account.

Frequently Asked Questions

What happens to my money if I close my account?

The bank returns your balance to you in full (assuming it is under $250,000 and the bank is solvent). You can withdraw it as cash, transfer it to another bank, or request a cashier's check. There is no penalty for closing an account, though some banks charge a fee if you close within a certain period after opening.

Can a bank take my money without permission?

A bank can deduct fees from your account without asking each time, as stated in your account agreement. It can also freeze your account if it suspects fraud or if you owe money to the government (tax debt, student loans). It cannot take money for a debt you owe to someone else unless a court orders it through a process called garnishment.

Why do banks charge overdraft fees?

An overdraft fee is charged when you spend more money than you have in your account. Banks charge this fee because they are covering the cost of the negative balance and the risk that you will not repay it. You can often opt out of overdraft coverage, which means transactions will be declined instead of going through and incurring a fee.

How do banks make money if interest rates are very low?

When interest rates are low, banks make less money from lending but increase revenue from fees, investment activities, and trading. They also reduce costs by paying less on deposits and cutting staff. Large banks with investment divisions can offset lending losses with profits from securities trading and advisory services.

Is my money safer at a big bank or a small bank?

Safety depends on FDIC insurance, not bank size. Both big and small banks are insured up to $250,000 per account holder. A small bank might fail more often than a large one, but your insured deposits are protected either way. The difference is how quickly you regain access — large banks usually have backup systems, while small banks might take longer.