How Banks Actually Make Money — and Why an Online Bank Pays More

A bank takes deposits, pays a low rate on them, lends the money at a higher rate, and keeps the difference. That difference is net interest income and it is the largest line for almost every retail bank.

On top of it sit two smaller lines: fees you pay directly, and interchange — a slice of every card transaction, paid by the merchant.

That is genuinely most of it. Everything else on a retail bank's product menu is a variation on making one of those three lines bigger.

The same spread has to cover a bank's costs. A national branch network is an enormous fixed cost — property, staff, cash logistics — and it is funded out of the gap between the deposit rate and the lending rate.

An online bank does not have that cost, so it can give more of the spread back as APY and still make the same margin. It is not generosity and it is not a promotional trick; it is a different cost structure producing a different price.

What you give up is the branch. Whether that matters depends on whether you deposit cash, need a cashier's cheque, or want somebody to sit across a desk from when something goes wrong.

Fee income is the smallest of the three lines at most large banks and it does the most to shape the products you actually encounter.

It is why a monthly maintenance fee comes with a waiver condition rather than being abolished — the condition is what makes you hold a balance or route a direct deposit, and both of those are worth more than the fee. It is why overdraft coverage is opt-in but heavily encouraged. It is why the out-of-network ATM charge is separate from the ATM operator's own.

None of that is hidden. It is disclosed in the account agreement and in the fee schedule, and the reason it works is that almost nobody reads either.

Every card transaction carries a fee paid by the merchant to the issuing bank. It is small per transaction and enormous in aggregate, and it is the engine behind card rewards.

So a cash back card is not the bank giving you money. It is the bank returning part of a fee the merchant paid, in order to make you use that card rather than another. The merchant, in turn, prices the fee into what everyone pays.

This also explains the shape of the rewards market: high rates in categories with high margins, caps on the generous ones, and the best offers reserved for customers who spend a lot and pay in full. A cardholder who revolves a balance is profitable through interest instead, which is a different and much larger line.

Four practical consequences, each of which follows directly from the three lines above.