Lending in banking is the business of taking in money from depositors and loaning it back out at a higher interest rate, with the bank keeping the difference. That difference, called net interest margin, averaged 3.39% across the U.S. banking industry at the end of 2025.1Federal Deposit Insurance Corporation. FDIC Quarterly Banking Profile Fourth Quarter 2025 It is how most commercial banks make the bulk of their income, and it is the mechanism that moves money from people who have it to people and businesses that need it to buy homes, grow, or cover short-term gaps.
How Banks Earn Money on the Loans They Make
The model is simple. A bank pays depositors one rate and charges borrowers a higher one. If depositors earn an average of 2% and the loan book yields 5.4%, the net interest margin is roughly 3.4%. That spread has to cover operating costs, absorb the loans that go bad, and still leave something for shareholders.
The spread moves with interest rates. When the Federal Reserve raises its benchmark rate, banks can charge more on loans, but they also face pressure to pay depositors more. The reverse happens when rates drop. Managing that balance between what loans earn and what funding costs is one of the central jobs of running a bank.
Where the Money to Lend Comes From
Customer deposits are the cheapest and steadiest source. Checking accounts, savings accounts, and certificates of deposit are all money the bank owes back to the depositor but can lend out in the meantime. On the balance sheet, deposits are liabilities and loans are assets. Banking is often described as turning short-term liabilities into long-term assets.
Deposits don’t always cover loan demand. Banks fill the gap through wholesale markets, including advances from the Federal Home Loan Bank system, which lends to member institutions at competitive rates.2Federal Housing Finance Agency. About FHLBank System The FHLB system raises that money by going to the debt markets several times a day.3Federal Deposit Insurance Corporation. Affordable Mortgage Lending Guide – Advances Banks can also issue commercial paper or borrow overnight from other banks in the federal funds market.
The secondary market adds another large source of cash. Fannie Mae and Freddie Mac buy qualifying mortgages from lenders, either holding them or packaging them into mortgage-backed securities for investors. The lender gets its money back and uses it to make new loans.4Federal Housing Finance Agency. About Fannie Mae and Freddie Mac That cycle is why a single bank can originate far more mortgage volume than its own deposits could ever fund.
The Main Types of Bank Loans
Bank lending breaks into three broad families, each with its own risk, pricing, and approval approach.
Consumer Loans
Consumer loans are credit extended to individuals for personal use. The most common products are credit cards, auto loans, and personal loans. Credit cards are revolving credit: borrow up to a limit, repay, borrow again. Auto loans and personal loans are installment credit with fixed repayment schedules.
Risk varies. Auto loans are secured by the vehicle, so the bank has something to repossess if the payments stop. Personal loans are often unsecured. Credit card balances carry the most risk because they are both unsecured and revolving, which is why their rates are substantially higher than auto loan rates. There is no federal cap on credit card interest rates for national banks, though most states impose their own limits.
Approval for consumer loans leans heavily on credit scores and the debt-to-income ratio. The score estimates how likely you are to default; the ratio shows whether your income can carry the new payment.
Commercial and Industrial Loans
Commercial and industrial loans give businesses capital for working capital needs, equipment, and expansion. The two main structures are term loans and revolving lines of credit. A term loan delivers a fixed amount with a set repayment schedule. A revolving line works like a corporate credit card, letting the business draw and repay up to a limit.
Approving one of these loans means digging into the business’s financials to see whether cash flow covers the debt. Banks often write protective covenants into the agreement, requiring the borrower to maintain specific financial ratios throughout the life of the loan. Violating a covenant can trigger a default even when payments are current. Business owners routinely underestimate that risk.
Real Estate Loans
Real estate lending covers residential mortgages and commercial real estate loans. The property itself is the collateral.
For residential mortgages, a key risk measure is the loan-to-value ratio, which compares the loan amount to the appraised value of the home. A $400,000 loan on a $500,000 house is an 80% LTV. The lower the LTV, the more equity the borrower has on the line, and the less exposed the bank is.
Commercial real estate loans fund income-producing properties: offices, apartments, retail centers. Underwriting shifts from the borrower’s personal income to the property’s ability to generate revenue. Banks compare net operating income to total debt payments using the debt service coverage ratio. Many lenders require a DSCR of at least 1.25, meaning the property’s annual cash flow has to exceed its debt obligation by 25%.
How Banks Decide Whether to Lend to You
Every lending decision comes down to one question: will this borrower pay the money back? Banks structure the answer around what the industry calls the Five Cs of Credit.
- Character: Your record of repaying debts, mostly reflected in your credit score and payment history.
- Capacity: Whether your income and cash flow can carry the new payment on top of what you already owe.
- Capital: How much of your own money you are putting into the deal. A borrower with real equity at stake is less likely to walk away.
- Collateral: Assets pledged to secure the loan. The bank cares about both current value and how easily the asset could be sold.
- Conditions: The purpose of the loan and the broader economy. A business expansion loan during a recession draws more scrutiny than one during a boom.
For most consumer loans, this analysis runs through automated credit scoring. For commercial loans, a loan officer reads the financial statements by hand, writes up a credit memorandum, and presents the deal to a loan committee or senior lending officer.
If you are buying a home, the review often starts before you have found the house. A prequalification gives you a rough number based on a quick look at your finances and a credit check. A pre-approval goes further: pay stubs, tax returns, bank statements, and a conditional commitment to lend a specific amount. Pre-approval carries far more weight with sellers because the bank has actually verified the numbers.
How Your Interest Rate Gets Set
The rate on any loan starts with the bank’s cost of funds, which is what the bank itself paid to get the money. On top of that, the bank adds a risk premium tied to how likely you are to default. Strong credit, steady income, and solid collateral mean a smaller premium. Weaker credentials mean a larger one.
The Federal Reserve’s benchmark rate shapes all of this. The federal funds rate, the rate banks charge each other overnight, is the foundation of most lending rates. Most banks set their prime rate about three percentage points above the fed funds rate. Many consumer and business loans are then priced as “prime plus” an additional spread. As of early 2026, the federal funds rate sits in the 3.50% to 3.75% range.
Loans carry either a fixed rate or a floating one tied to a benchmark index. Since the move away from LIBOR, the standard benchmark for floating-rate loans in the U.S. is the Secured Overnight Financing Rate, or SOFR, which is based on actual overnight borrowing in the Treasury repurchase market.5Federal Reserve Bank of New York. Alternative Reference Rates Committee – SOFR Starter Kit Part II A floating-rate loan priced at SOFR plus 2.5% moves up or down as SOFR moves. Fixed-rate loans lock the rate for the life of the loan, trading a slightly higher starting rate for predictability.
What Federal Law Requires Lenders to Tell You
Several federal laws govern how banks interact with borrowers. Knowing what they require matters more than most people realize, because the disclosures only help if you read them.
Truth in Lending Act
The Truth in Lending Act makes lenders disclose the cost of credit before you sign. For consumer loans, that means the annual percentage rate, the total finance charge, the amount financed, and the total of all payments over the life of the loan.6Office of the Law Revision Counsel. 15 USC Chapter 41, Subchapter I – Consumer Credit Cost Disclosure The APR is especially useful because it rolls fees into a single number, which makes comparing offers much easier. For 2026, the general disclosure requirements under Regulation Z apply to consumer credit transactions of $73,400 or less, though mortgages and private education loans are covered regardless of amount.7Federal Reserve Board. Agencies Announce Dollar Thresholds for Truth in Lending and Consumer Leasing Rules
Equal Credit Opportunity Act
The Equal Credit Opportunity Act bars lenders from discriminating against an applicant based on race, color, religion, national origin, sex, marital status, or age. A lender also cannot deny you credit because your income comes from public assistance or because you exercised a right under consumer protection law.8Office of the Law Revision Counsel. 15 USC 1691 – Scope of Prohibition It does not mean every applicant gets approved. It means the decision has to rest on legitimate financial factors.
Adverse Action Notices
If a bank denies your application based in whole or in part on something in a credit report, the Fair Credit Reporting Act requires the bank to tell you, give you the name and contact information of the credit bureau that supplied the report, tell you your credit score, and inform you of your right to a free copy of the report within 60 days.9Office of the Law Revision Counsel. 15 USC 1681m – Requirements on Users of Consumer Reports This is one of the most underused consumer protections in lending. The notice gives you what you need to find errors on your report and fix them before you apply somewhere else.
What Happens When a Borrower Can’t Pay
Missing payments triggers a chain of consequences that moves faster than most borrowers expect.
After a missed payment, the bank starts collections with notices and late fees. Most loan agreements include an acceleration clause giving the bank the right to declare the entire remaining balance due immediately if you breach the agreement. Acceleration rarely happens automatically; the bank has to choose to invoke it. If you cure the default first, you can often avoid the worst of what follows. Once the bank accelerates, the full balance is due and the bank’s options widen sharply.
For mortgages, federal rules generally stop a servicer from starting the legal foreclosure process until you are at least 120 days behind.10Consumer Financial Protection Bureau. How Long Will It Take Before I Face Foreclosure After that, the timeline depends on whether your state handles foreclosure through the courts (judicial) or outside them (non-judicial), and the full process typically runs anywhere from 5 to 24 months.
For unsecured loans and credit cards, banks that cannot collect eventually charge off the debt, writing it off as a loss for accounting purposes. A charge-off does not erase the obligation. The bank can still try to collect, sell the debt to a collection agency, or sue. A charge-off is devastating to your credit score and stays on your credit report for seven years.
The Tax Bill Nobody Expects
If a bank eventually forgives or cancels a debt, the IRS generally treats the forgiven amount as taxable income. A lender that cancels $600 or more must file Form 1099-C and send you a copy, and you are expected to report the cancelled amount on your return.11Internal Revenue Service. Publication 4681 – Canceled Debts, Foreclosures, Repossessions, and Abandonments This catches many borrowers off guard. After losing a home or settling a debt for less than owed, they get a tax bill on the forgiven portion.
There are important exceptions. Debt discharged in bankruptcy is excluded from taxable income. If you were insolvent when the debt was cancelled, meaning your total liabilities exceeded your total assets, you can exclude the cancelled amount to the extent of that insolvency. A separate exclusion for cancelled mortgage debt on a primary residence was available through 2025 but expired for discharges occurring after December 31, 2025, unless a written agreement was in place before that date.12Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
When Your Loan Gets Sold to Someone Else
Banks don’t hold every loan they originate. Selling loans frees up capital and balance sheet capacity to make new ones. The secondary mortgage market, dominated by Fannie Mae and Freddie Mac, exists for exactly that purpose.4Federal Housing Finance Agency. About Fannie Mae and Freddie Mac
When your loan is sold, the terms do not change. Your interest rate, monthly payment, and remaining balance stay exactly the same. What changes is where you send the payment. The original lender sometimes keeps the servicing (collecting payments and managing escrow) even after selling the loan itself. Often the servicing transfers along with the loan.
Federal law requires both the old and new servicers to notify you when a transfer happens. The outgoing servicer must send written notice at least 15 days before the transfer takes effect. The incoming servicer must notify you within 15 days after.13Office of the Law Revision Counsel. 12 USC 2605 – Servicing of Mortgage Loans and Administration of Escrow Accounts If the two servicers send a combined notice, it has to arrive at least 15 days before the transfer date.14Consumer Financial Protection Bureau. Mortgage Servicing Transfers – 1024.33 Both notices must give you the effective date, contact information for each servicer, and the dates to stop paying the old company and start paying the new one. A servicing transfer cannot change any other term of your mortgage.