Young Fools
What's Up With Banks

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Young Fools

You probably know a little bit about banking. You know that if you open a savings account at a bank, that the bank pays you interest. For example, maybe you open a bank account and deposit $100 in it. If the bank's interest rate at that time is five percent, it means that the bank will add 5% to your account each year. So in the first year, you'll have your $100 in the bank, and by the end of the year, the bank will have added $5 to it. (5% of $100 is $5.00.) At the end of the first year of your account, you have $105. Your money has grown!

Actually, though, you made more than 5%. That's because banks don't compound interest only once a year. They do it much more often. This makes a bit of a difference. In the example above, your money would probably have grown by something like $5.13, not $5.00. (I told you it was a 'bit' of a difference, right?)

Have you ever wondered why banks pay interest? Well, when you put your money into a bank, where do you think it goes? Does the bank lock it all up in a big, safe vault? Nope. Banks lend money to people.

Who borrows money from banks? All kinds of people. Butch and Twinkie Nelson, for example, are a newly-married couple. They want to buy a house, but do they have the $150,000 they need? Of course not. Butch only earns $8.00 per hour scraping the scales off fish. And Twinkie, earning $20,000 per year collecting money at a tollbooth on the highway, doesn't have that kind of cash, either. They clearly need to borrow money. So they borrow from a bank. (A loan for a house is called a mortgage.) Most people take out mortgages from banks when they buy houses. People often borrow, also, in order to pay for college. And a person who is starting up a new business will need to borrow money, too.

If a woman named Fiona wants to open an arcade in a mall, she may expect to make a lot of money as kids pile in to play games, but first she needs to borrow money. (In business terms, she needs capital, which is money and property that companies have.) Fiona needs enough money to rent space in the building, to buy or rent some pinball machines and other amusements, to hire some people work for her, and to place advertisements in newspapers. So while the bank is taking your money and lots of other people's money and is paying you all a little interest, it's also lending that money to others -- to people like Fiona. When it lends money, it charges interest. If a bank is paying you 5%, you can be sure that the same bank is charging people more than 5% interest for loans. That's how the bank makes its money -- on the difference. The bank takes your money, loans it out at maybe 8% interest, and then pays you 5%. Between 8% and 5%, there's a difference of 3% -- which the bank keeps for itself.

Interest rates change all the time, though, as the economy changes. Sometimes, for a few years, rates will be high, and the bank might pay you 6% or more for your savings account. In years like that, people borrowing money will be paying a lot -- maybe 10% or more. In the 1970s, interest rates were very high. In the early to mid-1990s, rates were very low. Many banks in 1996 paid less than 2% for savings accounts. This can be very depressing if you're trying to watch your money pile up in a savings account. Your $100 will grow by only $2 in a year. On the other hand, when rates are low, a lot of people decide it's a good time to buy a house, because they'll be charged very little interest on the loan.

Now that you have a handle on what banks do and how much they pay you in interest, look at our How To Invest area where we tell you some other ways you can make your money grow. You'll do well to compare them to a bank account, to see which one is likely to help your money grow best. Remember, banks make your money grow by paying interest. Interest is expressed as a percentage rate. And percentage rates -- or rates of return -- are one of the main things that investors need to focus on.