Guide to Banking: What Is a Bank and How Does It Work? | The Motley Fool (2024)

Most of us wouldn't feel very safe keeping all of our hard-earned cash under our pillows at night, so we open bank accounts and park our cash there instead. But picking the right bank or credit union account can be challenging, especially for those who are new to banking.

This guide can help you understand banks, types of bank accounts, how to compare banks, and how to pick the right one for you.

A bank is an institution where anyone (approved by the bank) can deposit savings and take out loans. Banks are often seen as a convenient and secure way to store money, and some account types also earn interest. Most banks have both online and in-person services.

Banks are for-profit organizations. At a bank, you can open checking and savings accounts, loans, credit cards, or other products. Almost anyone can join a bank.

How does a bank work?

Banks are in the business of making loans. Banks lend money to creditworthy borrowers, and then those loan customers pay back what they borrow plus interest. Charging interest and other fees is how banks earn profits for shareholders. Banks also pass some of this profit back to those with deposit accounts as a way to incentivize them to keep money there.

In order to operate, a bank must have a charter, which is essentially a license to operate. U.S. banks can be chartered on the national level or the state level. Nationally chartered banks are overseen by the U.S. Department of the Comptroller of Currency. This organization makes sure the banks operate within the laws. It also requires nationally chartered banks to maintain FDIC insurance. This protects your money up to $250,000 per person per bank in the event of bank failure.

State-chartered banks operate under the regulations of the state they have their charter through, and they're overseen by a state institution. These banks are typically smaller than nationally chartered banks and operate in a limited area.

There are many ways to break banks into types. We'll look at two of the most common methods below.

Types of banks by services offered

One way to categorize banks is to look at the services they offer to their customers. Here are some common types you might come across:

• Retail banks: These banks offer personal bank accounts and loans directly to consumers. Most banks that you're familiar with fall into this category.
• Commercial banks: These banks cater to businesses and offer a variety of business bank accounts and loans. Many popular banks have retail and commercial divisions.
• Investment banks: Investment banks typically deal with corporate clientele and often assist with mergers and acquisitions.
• Central banks: Central banks, like the U.S. Federal Reserve, don't deal directly with the people. They help maintain economic stability by setting appropriate economic policies, and these policies affect the services other banks offer to their customers. For example, the Federal Reserve sets the federal funds rate. This determines how much banks charge to borrow money from each other, and banks in turn use it to determine the interest rates they charge their customers on loans.

Types of banks by service area

Another way to compare banks is by looking at their service area. These are the main categories you'll find here:

• National banks: National banks typically have nationwide branch and ATM networks and serve a wide variety of customers. They often have large budgets and strong online and mobile banking tools, and some have international banking divisions as well.
• Regional banks: Regional banks typically operate in a smaller area -- perhaps just a few states. They may have a lot of branches and ATMs in their area, but you won't find any if you travel outside of it. For some people, these banks are a good compromise if they want a personal banking experience without restricting themselves to a local community bank.
• Community banks: Community banks operate in a small area, usually within a single state. In some cases, a community bank may only have a single branch. But what these banks lack in size, they often make up for with excellent customer service
• Online banks: Online banks don't have any branches, though most have nationwide ATM networks. They're becoming increasingly popular because they're open to just about anyone and they have lower fees and higher interest rates on savings accounts than the other bank types listed here. But depositing cash can be tricky with online banks.

Credit unions are similar to banks in many ways. Both offer a variety of bank accounts for their customers to choose from and lend money to qualifying borrowers. But unlike banks, credit unions are nonprofit institutions. That means any money a credit union earns goes back to its members. As a result, credit unions can often offer more competitive rates and lower fees than some large national banks.

But credit unions have their drawbacks as well. Most only operate in a small area and they have membership requirements that restrict who can join. Their online and mobile banking tools often aren't as good as those you'll find with large banks, either. But they could still be a good fit for those who value customer service and don't travel often.

Types of bank accounts

There are four main types of bank accounts: checking accounts, savings accounts, CDs, and MMAs. We'll go over each one at a time below.

Checking accounts

Best for: People who want a safe place to keep the money they use to pay bills.

Not for: People who want to earn a lot of interest on their money.

You should open a checking account for money you plan to use for everyday spending. You can withdraw money as often as you like, as long as you don't withdraw more money than you have. (There are restrictions on withdraws from savings accounts, CDs, and money market accounts.)

Savings accounts

Best for: Those who want a low-risk way to grow their money.

Not for: Those who plan to withdraw money frequently from their account.

A savings account is a low-risk account where you can earn interest on your money. It's a great place to save for an emergency fund, a vacation, or a down payment on a home. However, you can only withdraw money from a savings account account a handful of times every month -- so it's not great for paying bills. Checking accounts are better for bills.

Money market accounts (MMAs)

Best for: Those who want to earn a high interest rate without sacrificing easy access to their money.

Not for: Those with a small amount of savings who cannot meet the minimum balance requirements.

If checking and savings accounts had a baby, that baby would be a money market account (MMA). MMAs often come with checks or debit cards, like a checking account. They also have high interest rates -- like savings accounts. However, they usually have high minimum balances. You'll have to be able to keep a hefty chunk of cash in the bank at all times if you want to have an MMA.

Certificates of deposit (CDs)

Best for: Those who want to earn a higher interest rate on their savings and don't need to spend that money anytime soon.

Not for: Those who think they'll need to withdraw their money before the CD's maturity date.

A certificate of deposit (CD), also known as a share certificate if you're using a credit union, is a special type of savings account that offers a higher interest rate -- but there's a catch. When you put the money into a CD, you're agreeing that you won't touch it for the length of the CD term. This can be anywhere from a few months to several years. Usually, the longer the loan term, the higher the interest rate. The best CDs can offer APYs of around 5%.

What's the best bank account?

Once you've narrowed your list down to a couple banks, take a look at their accounts and ask the following questions.

• Would it be free for you to use ATMs?
  Look for banks with a large ATM network, or accounts that offer ATM fee reimbursem*nt for out-of-network ATMs.
• Do any accounts have a high interest rate (APY)?
  This is how much money you'll earn in interest.
• Do the accounts have low fees?
  To see all the fees associated with an account, you can ask for something called a "fee schedule."
• Do the accounts have minimum balances you can maintain?
• Do any of the accounts offer an attractive sign-up bonus?

How to find the best bank for you

When you're choosing a bank, start by deciding whether you want to open an account at a bank or a credit union. Then, think about the following features.

FDIC or NCUA insurance

This keeps your money safe if the bank or credit union fails. FDIC insurance is a guarantee that the bank will have some or all of your money available for you to withdraw (within account requirements and limitations) -- even if the bank itself fails.

You'll probably never need FDIC or NCUA insurance, but if you do, you'll really need it. Make sure that your bank or credit union is FDIC insured before you sign up. Most state their member ID number on the footer of their website. You can also contact the bank or credit union if you're unsure, but most should have the applicable type of insurance.

Availability and convenience

To find the right financial institution for you, check where and how you can access your account. If you prefer banking in person, check whether the bank you're interested in has branches near you (or nationwide, if that fits your lifestyle).

Most banks offer some online functionality these days, and some banks are fully online. But it's worth checking out a bank's mobile banking app (if it has one) to see how much of your banking you can do from your phone or other device. This could be especially helpful if you're opening a joint account with someone who doesn't live near you.

Customer service

Look into how you can contact the bank or credit union if you have questions or problems with your account. Check into its customer service hours as well. Some national banks have 24/7 customer support, while smaller regional banks and credit unions may only operate during normal business hours.

Mortgages, loans, and other banking products

You may only be looking for a checking or savings account now, but in the future you might need to buy a home or start a business and then you'll need a mortgage or a business loan. Anticipating your future needs and choosing a bank or credit union that can accommodate them can prevent you from having to jump ship as your financial needs change.