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A look behind the scenes at how banks use deposits to provide loans to other people.
If you put $100 into a bank account, do you think it just sits in a dark vault gathering dust? In reality, your money might be out helping a neighbor buy a car or helping a new pizza shop open downtown!
When you put money into a savings account, you are a depositor. The bank doesn't just lock your cash away; they keep a small portion (called a reserve) and lend the rest to other people, known as borrowers. This movement of money is called the circular flow. It ensures that money is always 'working' instead of sitting still. The bank acts like a middleman, connecting people who have extra money with people who need money to start a business, buy a house, or go to college.
1. Sarah deposits 10, in their vault. 3. The bank takes the remaining 100 in her account, but $90 of it is being used by Mr. Jones to help his business!
Quick Check
In the circular flow of money, what do we call the person who puts money into the bank?
Answer
The depositor.
Banks are businesses, and like any business, they need to make a profit. They do this through interest. Interest is a fee paid for using someone else's money. The bank pays you a small amount of interest for keeping your money with them. However, they charge borrowers a higher amount of interest for taking out a loan. The difference between the interest they collect and the interest they pay out is how the bank pays its employees and makes money.
$$70 - 10 = $60$$
Quick Check
Why does a bank charge a borrower more interest than they pay to a depositor?
Answer
To earn a profit and cover their business costs.
When banks lend money, they aren't just making a profit; they are fueling the local economy. A loan might allow a family to buy their first home, which creates work for builders. A loan might help a scientist start a lab to invent new medicine. This creates jobs and makes the community a better place to live. Without banks, it would be very hard for most people to save up enough cash to pay for big, important things all at once.
1. A bank lends $50,000 to Maya to open a bakery. 2. Maya uses the money to buy ovens from a local supply store and hire two assistants. 3. The supply store and the assistants now have money, which they deposit back into the bank. 4. The bank now has new deposits to lend to the next person! This is how one loan can grow the entire town's wealth.
What is the primary way a bank makes a profit?
If a bank receives in interest from loans and pays out in interest to savers, what is their profit?
Banks are required to keep every single dollar of your deposit in the vault at all times.
Review Tomorrow
Tomorrow, try to explain to a friend or family member the three main 'players' in the bank's money cycle: the depositor, the bank, and the borrower.
Practice Activity
Look up the current 'Savings Interest Rate' at a local bank online. Then, look up their 'Auto Loan Interest Rate.' Which one is higher? By how much?