Why banks love your money

Ever wondered what happens to your money once you put it into a bank? Does it sit around idly in a safe deposit box until you decide to take it out?

Well yes, some of it does lie idle. A bank is legally required to keep part of the money aside. But, what about the rest…?

How does a bank make money?

The answer is simple – it puts yours to work! Your money is lent out to those who want it. The profit of the bank lies in the difference between the interest it pays you to deposit and the interest it charges to the customer who is taking the loan.

For instance, you keep AED 100,000 in a savings account at the rate of one percent per annum. (The average rate of interest on a savings account on Souqalmal.com being 1.5 percent.) By year end, you earn AED 1,000 on your savings.

[Compare UAE savings accounts | Compare Saudi savings accounts]

While you were waiting, the bank lent your AED 100,000 to someone as a personal loan at a much higher interest rate. (Current rates can be checked on Souqalmal.com; on average, they range from 4.75 to 26 percent for a personal loan.)

[Compare UAE personal loans | Compare Saudi personal loans]

In the end, the borrower paid the bank back a minimum of AED 4,750 as interest in the first year. Subtracting the interest the bank owed you, it made a nice AED 3,750 on your hard-earned cash!

And remember, you are just one of the many, many such customers a bank has…

But logistically, how does it work?

• When you keep your money in a fixed deposit account, you commit to keep it for a fixed tenure ranging from one to 12 months. This allows a bank to plan on how to use your money.
• On savings and current accounts, not everyone withdraws their funds at the same time. From experience, banks can see the withdrawal behavior of their customers and decide how much can be lent out without trouble.
• If one bank falls short of money, it can always borrow from another bank. Known as an interbank market, lending and borrowing within financial institutions has its own interest rates and structure. [What’s the EIBOR anyway?]

Sounds good! Why doesn’t everyone open a bank?

• Risk-to-reward ratio: It’s a high reward-business, yes, but banks also run a high risk of loss, when customers who take out loans don’t pay them back. Known as defaulters, such customers can potentially wipe out entire banks’ profits.

• Heavy investment: From branches and offices to ATM networks, security, online banking and the sheer amount of human resource, running a bank requires a lot of cash infusion.

So, as a customer – should you be taking a loan, if it’s avoidable?

Let’s take an example. You need to buy a car, but have a liquidity crunch at home, so you decide to take a loan.

Let’s say the bank offers you an interest or profit rate of four percent reducing on a car worth about AED 200,000. You will be paying the bank AED 8,000 a year as interest/ profit.

Meanwhile, if you kept AED 200,000 in savings with your bank, earning an interest rate or targeted profit of one percent per annum, you would be making AED 2,000 a year.

So basically, when you take a loan or finance you end up paying your bank AED 6,000 (AED 8,000 minus AED 2,000) to access the very cash that you gave to the bank in the first place.

[Compare UAE car loans | Compare Saudi car finance]

Now you know why banks love your money! So what can you do? Always compare. Only take the best deal out there, whether it’s a bank account, personal loan, home loan, car loan or credit card.