Here's What Really Happens to Your Money When You Put It in the Bank -- and Why It's Important

Yes, banks use your money to make money, but it's all for the greater good.

Have you ever wondered what happens to your money once you've deposited it into your savings account? You might be surprised by the way your bank or credit union puts the money to work.

Once your funds are safely in your account, you become a creditor of sorts. In essence, you're lending the money to your bank. Once they accept your deposit, they agree to refund the amount you've deposited on demand. And depending on whether it's an interest-bearing account or not, they also agree to return the money with interest.

Making money off your money

Making loans is a bank's bread and butter; it's how they keep the lights on, and ultimately, how they remain in business. And that's where your money comes in.

Let's say you deposit $10,000 into your savings account. Another customer comes in and applies for a $9,000 loan. The bank is allowed to hang onto $1,000 of the money you deposited and use the remaining $9,000 to make the loan.

It's all legitimate, thanks to the fractional reserve system under which U.S. banks operate. Because of the fractional reserve system, banks must only keep a fraction of deposits in their reserve and are free to loan out the remaining money.

For the sake of illustration, let's say the bank charges the borrower an APR of 10%, and that you're earning an interest rate of 1% on your savings accounts. They get to keep the 9% difference.

Why fractional reserve exists

Imagine the dreariest looking town you've ever driven through. Now, what if there was no hope of new businesses moving in, and less money available for people to buy homes? What if financing a vehicle became too difficult for most people to pull off due to tightened lending practices?

While it may sound quite dramatic, the fractional reserve system is designed to prevent such a scenario. Because banks only have to keep a portion of deposits on hand, they have more money to lend, and it's those dollars that keep the economy humming.

Reserve requirement ratio

Fractional reserve banking is the system used in most countries, and it's highly regulated. In the U.S., that means it's monitored by the Federal Reserve System. The Fed ensures that all banks keep a set percentage of deposits in reserve. This is called the "reserve requirement ratio."

The Fed raises or lowers the reserve requirement ratio based on how the economy is doing. It can be used to slow the economy when inflation gets out of hand or to infuse a sluggish economy with low-interest loans. Let's say the economy is slogging along, and the Fed lowers the reserve requirement. Suddenly, banks have more money available to lend, and because of that, can set lower interest rates.

The reserve requirement helps explain why some banks limit the amount a customer can withdraw from their account to $10,000 or $20,000 per day. Setting these limits helps ensure there's enough cash available for everyone who wants to make a withdrawal.

The next time you make a deposit, a large portion of the funds may be used to finance a young family's first mortgage, fund a startup business, or pay for a couple's 50th anniversary vacation. In other words, it will be put to good use.