The general idea behind banking is pretty simple. You offer customers a certain rate of interest to deposit their money with your bank, and in turn, you lend that money out to other customers who are willing to pay a higher rate to borrow. Whatever margin you can achieve between what you pay and what you earn is pure profit. This interest income has traditionally been the primary source of revenue for banking institutions.
However, banks have increasingly looked for other sources of income that aren't dependent on interest rates. The search for non-interest income has led to an increasing number of fees and other charges that can improve the bottom lines of bank financial statements at your expense. Although many of these fees are relatively small, they can add up to substantial amounts, especially when related charges come in close succession.
Replacing lost income
Part of the reason why banks have sought more revenue from sources other than interest income is that banks can't count on a stable flow of interest-related revenue. Fluctuations in the relative level of interest rates create cycles in bank revenues from their interest margins. Specifically, most banks tend to take deposits that customers can withdraw either on demand or within a relatively short period. However, they lend money for longer periods of time. Banks therefore are most profitable when the short-term interest rates they must pay for deposits are significantly lower than the longer-term interest rates they collect from borrowers on their loans. As a result, when the yield curve is positively sloped, banks often do quite well.
With the current inversion in the yield curve, on the other hand, interest income at banking institutions is suffering. The Federal Deposit Insurance Corporation's most recent quarterly profile of banks shows that net interest margins at large commercial banks are currently at their lowest level in 17 years. Meanwhile, even though growth in assets has kept interest income rising, non-interest income has risen at a faster rate. For instance, in the latest quarterly report for Fifth Third (Nasdaq: FITB ) , interest income fell from last year's level, but non-interest income rose 6%. Similarly, at M&T Bank (NYSE: MTB ) , net interest income for 2006 rose just 1% from 2005 levels, but non-interest income rose 10%.
What to look out for
When you're opening a bank account, it's easy to gloss over the pages of disclosures you receive. Yet if you take the time to look through those disclosures, you'll find a lot of information about the fees that you may have to pay. You're probably familiar with the most common fees, such as monthly service charges if you don't keep a certain minimum amount in your bank account and ATM charges if you withdraw money from another bank's ATM.
The most lucrative fees for banks, however, are overdraft and other miscellaneous fees. For instance, many banks now charge overdraft fees that rise dramatically every day that you don't correct the overdraft. So if you're not aware of an overdraft, you may find not only that a particular check has left you with insufficient funds but also that every subsequent check has resulted in an additional fee that's even higher. In addition, you can't count on your bank to minimize your overdraft fees. For example, if you have $100 in your account and write two checks, one for $10 and one for $120, you may think that the first check will clear, leaving you with only one overdraft fee. However, the bank may apply the larger check first, resulting in two charges.
If you can think of something banks do for customers, you can probably find a bank that charges a fee for it. You may receive a bank statement in the mail every month, but if you need your bank to provide a written verification of your account in order to get a mortgage or other loan from another lender, you might have to pay a fee of $10 or $20. While most banks have moved away from fees for seeing a live teller rather than using an ATM, you may still find a charge at some banks if you speak to a customer service representative on the phone. Wells Fargo (NYSE: WFC ) , for example, charges a $2 fee if you speak to a banker on the phone when you could have used their automated system to get the same information. Similarly, with check processing technology moving more toward paperless electronic checks, getting copies of written checks can be expensive as well.
The best way to avoid fees is to make sure you understand what fees your bank charges for certain transactions or activities before you need them. In general, it's easy to find out what the most common charges will be. However, if you're doing something unusual, be sure to ask if there's an associated fee for that particular service. Because many banks have different fee schedules, you may be able to get a better deal or not have to pay a fee at all by using another bank if you have more than one account.
For many customers, bank fees are just a part of their financial lives. Realizing just how profitable these fees are for banks may provide you with the motivation to make changes in your financial life that will put you in a position not to have to pay them anymore.
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Fool contributor Dan Caplinger sometimes goes overboard to avoid fees, including walking $3,000 in cash across the street rather than paying for a cashier's check. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy doesn't cost a cent.