How does money grow in a bank?
When you give your money to the bank, it uses that money to make more money. This allows the bank to give you something extra to keep you happy. It is like a cherry on the top of your ice-cream. The ice cream is your money and the cherry is what the bank gives you extra. This extra money is called interest. Also see Volume 5.
How does a bank keep your money safe and still pay you interest? The Bank keeps some of your money at the bank and puts the rest to work. Suppose you deposit your $100 savings in your favorite bank. The Bank will take that $100 and loan it to someone who needs it, but not for free.
First, the bank finds out why this person needs money and then checks this person’s credit history for his/her ability to repay the loan. The bank is trying to estimate what are the chances of getting the money back.
Second, if the chances for repayment by this person are good then the bank gives (or lends) the money out to this person. When the bank lends the money, it acts as a money lender. The person who needs money from the bank is called the borrower. The amount the person borrows is called the principal. The bank charges extra money on the principal. This extra money that the bank charges from the borrower is called the interest. In addition to the interest, the borrower has an obligation to return the principal in a fixed amount of time.
For a principal loan amount of $100, suppose the bank charges $10 interest from the borrower for the fixed time of one year. The bank takes this $10, pays you some of it, say $3, and keeps the remaining $7 for itself. Not a bad deal! You see, the bank is also as smart as you are. When you deposit your money to the bank, it uses that money to make more money by charging more than it pays you and keeps the difference as its profit.
So now you and the borrower are happy. You are happy because you got interest on your savings and the borrower is happy because he/she got the money to do what he/she wanted to do, like buying a house, or sending their kids to college, or buying a car. If the bank had not given the borrower the money he/she needed, the borrower would not have been able to do things he/she wanted to do.
Are you wondering why the bank gets to keep some money that the borrower pays as interest to the bank? After all, it was your money that the bank gave to the borrower. Well, the bank needs money to do its job: like finding borrowers, making sure that borrowers repay the loan, pay salaries to bank employees, pay for bank security, and many other things that businesses have to do. Banks also need to make some profit for its owners.
Sometimes, borrowers fail to repay the loan they took from the bank. Remember, that the bank still has to give you the interest that it promised to you, as well as return your savings ($100 that you deposited in the bank) whenever you ask for it. When borrowers fail to repay, the banks have to make good their promise out of their own pocket. Obviously, it costs money to the bank. So they get to keep some money too.