Why Banks Lend Money

Banks are established to do business. No bank is there that will be interested in doing charity work. Now lending money is a risky operation, since there is always the risk of money not coming back from the borrower. Then the main question arises that why do banks lend money?

The answer to this is that, banks do business by lending money at higher rates as compared to the interest rate they pay to the account holders. I will explain this point wise.

1. We go to bank to open a savings bank account. A saving bank account is one of the lowest interest accounts. So it is a form of bank borrowing the money from us at very low rates.

2. Now there are people who are in need of money and want it immediately, they go to the bank and ask for loans. It might be for any reason like personal loan, home and housing loan, car loan, etc.

3. The bank lend money to these borrowers at a higher rate then it is paying to the saving account holders.

4. The difference in interest is the earning benefit for the bank. 

Suppose that a bank pays an interest of 4% per annum on Saving bank account. It charges an interest rate of 14% on car loans. So an amount of $50000 deposited in the saving bank account will become $52000, so a benefit of $2000 for the saving bank account holder.

On the other hand the bank lends the same money to a borrower for car loan at 14%, so the bank receives $57000 at the end of year. Therefore the bank profited by $7000 - $2000 = $5000. So we see that bank is earning without investing anything. But the actual case is that the bank bears the risk of the borrower defaulting on the loan. It is similar to the strategy of making money by taking a loan.

All the banks that lend money usually perform thorough background check of the borrowers credit and reputation in the market, so as to ensure that there money will be safe.

Now one of my friends asked me that, why is it that the banks give loans to those who already have money, and not to those who do not? The answer to this question is that the banks need to make sure that there money is safe. If a person does not have money to fulfill his means now, then there is a high chance that he will not be able to repay it later. On the other hand those who have money have saved it and know how to take care of money.

There are many other factors like the past credit records, reasons for borrowing money, is the person borrowing for investing or does he want to take care of his expenses.

Cheers,
Amit