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Welcome to our Math lesson on How does a Bank Operate?, this is the first lesson of our suite of math lessons covering the topic of Applications of Percentage in Banking. Simple and Compound Interest, you can find links to the other lessons within this tutorial and access additional Math learning resources below this lesson.
All banks have one thing in common: they apply interest on the funds of clients who decide to have agreements with them. Interest represent the extra money one customer has to pay to a bank when he/she loans money from it or receive when he/she decides to deposit money in that bank.
In simple terms, a bank is an institution that accepts customer deposits and offers loans to individuals and corporate clients. Banks make money by charging higher interest on loans than the interest they pay on customer deposits.
There are some banks which do not accept customer deposits and only offer loans to clients (investment funds). Their owners have enough money, so they don't need money from customers for their investments. They only lend money to their customers and the latter repay the money received in instalments based on the rates determined through mutual agreement. However, most banks work in both ways mentioned earlier, i.e. they accept customer deposits but also offer loans for those who need money. Then, they may or may not invest the money a customer deposits in other sectors of economy to have extra earnings, depending on the strategy they apply to extract profits from their activity.
For example, a customer deposits $10,000 in a bank and he receives an extra $1,200 as interest for the period of deposit. Hence, the customer receives, in total, $10,000 + $1,200 = $11,200 from the bank. During the same period, the bank invests the money in profitable activities or lends them to other customers and receives let's say an extra $2,000 from this activity. Thus, the bank receives in total $10,000 + $2,000 = $12,000 from this activity. The difference between these two amounts, i.e. $12,000 - $11,200 = $800 represents the bank's profit. This is a simple example that illustrates the financial logic of a banks operation.
The original amount deposited or loaned is called the principal. In our example, the principal (in short P) is $10,000.
Basically, when you deposit money in a bank, you are lending your money to the bank, which on the other hand uses your money to repay other customers or to invest in other assets. In this way, you indirectly become an investor in the economy through your bank. On the other hand, when you borrow money from a bank, they gain profit from your money through interest you have to pay in addition to the principal borrowed.
Interest rates (R) are expressed in percentage (of principal) and usually they are calculated on a yearly base (per annum). Thus, when you read the interest rates offered by a bank, you are reading the percentage of profit you earn in a year by loaning your money to the bank.
Interest and interest rates are two different things. Interest (I) express the extra money you receive from or pay to the bank after making a deposit to or borrowing money from it, while interest rates (R) represent the percentage of the principal you earn or pay in a year when depositing or borrowing money from bank.
There are two types of interest: simple and compound, we will discuss these in the upcoming paragraphs.
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