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Updated on Wednesday, November 20, 2019
Banks and credit unions share some broad similarities: They help their customers borrow money, build savings and invest for the future. Both credit unions and banks make money by charging interest on loans and charging fees for banking services. But their business models are very different in many ways, mainly in regards to what they do with their profits.
Banks are for-profit enterprises that serve all and any customers who come to them, and distribute profits to shareholders. Credit unions are not-for-profit institutions that only serve people who become members, often by requiring them to meet certain membership criteria. Credit unions reward their members with bonus dividends or lower-cost services, rather than redistributing earnings to investors.
How banks and credit unions make money
Banks and credit unions both make money by lending out a portion of their deposits, charging interest on those loans and collecting fees and charges for various financial services, such as investing and wealth management.
Interest on loans
The most significant source of profits for banks and credit unions is charging interest on loans to consumers. Common types of loans offered by banks and credit unions include mortgages, home equity lines of credit (HELOCs), auto loans and personal loans, said Ken Tumin, founder of DepositAccounts.com, a LendingTree company.
Banks pay interest on deposits — checking accounts, savings accounts and certificates of deposit — but the interest they earn from making loans is typically higher than what they pay for deposits. In the banking business, the difference between these two types of interest is known as the “spread.”
If a bank pays out 1% interest on $200,000 worth of CDs, and receives 4.5% interest on a $200,000 mortgage, the difference — the spread — is how the bank makes money. Banks have to comply with rules on how many loans they can make relative to their asset bases.
Another way that banks and credit unions make money is by charging consumers fees for a variety of services, Tumin said. Commonly charged fees include:
- Overdraft fees: Overdraft fees comprise 60% of the fees charged by banks, and they tend to fall disproportionately on lower-income customers. Banks and credit unions charge these fees when you don’t have enough money to cover your payment or withdrawal. Fees can run as high as $36 per overdraft transaction.
- Interchange fees: Banks and credit unions charge merchants fees when you use your credit or debit card, which are known as interchange fees. If a consumer makes a purchase, money is withdrawn from their account — and the merchant pays a fee to both the bank and the credit card company for the transaction.
- Checking account fees: Monthly fees may be associated with a checking account, or fees may be levied if a consumer doesn’t maintain a minimum balance in the account.
- ATM fees: If you use another financial institution’s ATM, you typically pay a fee to do so, which goes into that bank or credit union’s pocket. In addition, your own bank may charge you a fee.
- In-branch service fees: If you need a cashier’s check, money order, notary or lock box storage, banks charge per-use or annual fees for these services.
- Document fees: Banks may charge a fee to pull historical bank records pre-dating a certain time period or to provide print copies of cashed checks. Banks may also charge fees for check printing or paper statements.
- Loan origination fees: Banks charge fees to “originate” loans, including home loans and personal loans. Loan origination fees may be a one-time flat fee or a percentage of a loan. They may sound low (1%, for instance) but can actually be substantial when considering the total size of the loan.
- Late fees: Banks charge late fees when borrowers pay credit cards, mortgage loans, personal loans and other forms of debt past the bill’s due date (or past a grace period, which is a few days past the due date). When a checking account is overdrawn, there may be additional late fees if it is not brought back to or above $0 swiftly.
- Early withdrawal fees: Those who open CDs at banks will pay early withdrawal fees if they withdraw funds before their certificate’s term expires. These fees can cut into earnings from a CD.
Many banks offer financial advisory and wealth management services. Institutions charge either a percentage of assets under management or per-transaction brokerage fees.
Additionally, some banks offer private banking services to high-net-worth consumers, charging an annual management fee as a percentage of the assets under management. Banks also offer access to investment products for customers in lower wealth brackets.
Credit unions cannot offer financial advisory or wealth management services directly, so they provide them by affiliating with partner registered investment advisors or registered broker-dealers. Credit unions offer these services as a benefit to consumers who want investing advice, and they may make money indirectly through referral fees or other partnerships arranged with an investment advising company.
What do banks and credit unions do with their profits?
Credit unions do not have to pay taxes since they are not-for-profit organizations, which means they avoid one major expense that banks need to pay. Additionally, because credit unions are owned by their members rather than by shareholders, they aren’t focused on generating profits for shareholders like banks are. Often, credit unions return profits to their members as dividends, or they may offer reduced fees or better interest rates on loans or deposit accounts, which can, in turn, attract new members.
Banks, on the other hand, are owned by investors and operate as for-profit institutions. They use their profits to provide returns to shareholders (especially if they’re publicly traded, as most larger banks are), and to pay state and federal taxes, which they must pay as for-profit organizations.
How online banking impacts banks and credit unions
Brick-and-mortar banks and credit unions have been facing more and more competition from online banks. Online banks tend to charge lower account fees than credit unions and pay out higher interest rates on deposits, said Tumin.
While online banks don’t have physical branch locations, they nonetheless offer a compelling proposition to consumers. In response, brick-and-mortar banks are beating them by joining them, offering online banking services of their own to address competition from apps and other tools, which threaten to reduce payment-related revenue by as much as 15% by 2025, according to a report published by Accenture, a professional services firm.
Going forward, banks’ business models will have to change to accommodate the anticipated reduction in fee income. But while these tools may not add revenue for banks, they could potentially lower branch operation costs, which are substantial. By putting more power in consumer hands, a big bank could reduce its branch count, branch hours or individual branch teller staff hours.
“For banks, these tools may be more about cutting back on expenses than adding revenue,” Tumin said.
For credit unions, providing these tools offers the conveniences that banks, which typically have larger branch networks, present. Since credit unions aren’t driven to provide returns to shareholders on Wall Street and are instead driven to manage so that their members receive benefits and favorable rates, credit unions can choose which services are for benefit versus for profit.
Are banks or credit unions better for your money?
Now that you know how banks and credit unions make money, you may be wondering which option is best for your money. As with most financial questions, the answer largely depends on what’s most important to you.
Online banks offer the most compelling savings account rates, with the best online savings accounts offering an APY of 1.70% or higher. Pair this with their low-fee checking accounts, and online banks are a compelling option for many consumers, although a lack of branches may deter some people.
Brick-and-mortar bank networks may be more convenient, offering more branches and more sophisticated online banking and investing options. These benefits are positives for some busy consumers, but the convenience comes at a cost — especially when it comes to overdraft and other fees.
“Credit unions may be more consumer-friendly,” Tumin said, citing their low account fees and balance minimums. Because credit unions are member-owned and locally driven, they may give back to their communities and their members. However, they are not open to everyone, as a consumer generally can’t join a credit union for aerospace or military members if they’ve never worked in those fields, for example.