If you opened a bank account within the last year, you might be among the growing number of Americans who did so in their pajamas. In fact, the number of U.S. consumers opening an online-only bank account tripled in 2020 compared to just a few years prior. (Technically, there is scant data on what online bank customers were wearing).
And the largest of the online or digital banks, Chime, now counts itself among the ten largest U.S. banks in terms of the number of customers who identify it as their “primary bank.”
With online banks on the rise, we take a look at the nuts and bolts of online banks, their pros and cons compared to brick and mortar banks, and some considerations to guide those who might be considering an alternative to traditional banks.
What are online banks?
If you think in terms of typical consumer checking or savings accounts, the concept of online banks is pretty simple. Online banks are banks without physical branches.
(Let’s put a pin in that term bank for a minute. We’ll get back to it.) Without physical branches, nearly all interaction–from setup to funding to bill pay–is online or through a mobile app. Online banks provide a Visa or Mastercard debit card that can be used the same as a traditional bank debit card.
Without the costs of branches, online banks can offer some distinct advantages over traditional banks, such as higher interest rates for checking and saving accounts and lower fees.
But there may be an additional benefit. Because online banks lose the physical branches, they design mobile apps and web portals that can replace the branch, rather than supplement it.
Online Banks, Neobanks, Mobile Banks, and Challenger Banks
That gets us back to the term bank. Many online-only banks aren’t banks at all. They’re fintechs–financial technology companies–that develop the user experience for customers. That’s given rise to the terms neobank, mobile bank, and challenger bank to describe those fintechs that offer banking services. They all mean the same thing.
In each instance, neobanks have a sponsor bank that holds customer funds. Those accounts are protected by the same FDIC insurance that protects traditional bank accounts.
Advantages of Online Banks
Whether they’re best referred to as online banks, neobanks, or mobile banks, for most consumers, the question is what are the advantages.
To paraphrase James Carville, it’s the money, stupid.
By dropping the branches, online banks also lose the costs associated with them. Consider this. Chase Bank maintains over 5,000 branches in the U.S. Wells Fargo over 8,000. Those branches come with heavy costs of the physical space, furnishings, and staff to man them.
Without those costs, online banks can compete for consumers’ deposits by eliminating many (or all) of the fees charged by traditional brick and mortar banks.
Fees like monthly fees or the less common, but crazy-high, overdraft fees.
Compare the three largest banks to their online-only counterparts. Chase, Bank of America, and Wells Fargo charge $10 – 14 just in monthly fees for their basic checking accounts. Two of the three largest online banks, Chime and Ally charge $0. Dave charges $1.
With traditional banks, the opportunity to earn income on your account balance seems like a thing of the past. Rates on savings accounts are anemic–averaging .04% in 2021. Interest on checking accounts is less still, usually with additional minimum balance requirements or other conditions.
Online banks tend to be more generous. Many pay more than ten times the interest offered by traditional banks. GO2Bank is at the top of the list for smaller savings balances. It pays a 1% APY on its savings account balances up to $5,000. It pays a reduced rate for higher balances, but still higher than most brick and mortar banks. Marcus, an online savings account offered by Goldman Sachs, pays .5% APY on its account with no limits. The same rate applies to Chime accounts.
That’s not to say that all online banks offer higher interest rates than all traditional banks. Like brick and mortar banks, rates differ among online accounts. Dave, for instance, doesn’t offer an interest-bearing account. It focuses more on other features, such as interest-free paycheck loans, to appeal to consumers. But if you’re searching for higher savings yields, you’ll likely find the best return among the online-only banking options.
No Minimum Balances
Online-only banks tend to cast themselves as a banking solution for everyone. And they reinforce that notion by ditching the minimum balance requirement. Most of them, like N26, Chime, and SoFi, have no minimum balance to open the account and no “penalty” fee for falling below a minimum balance.
Perhaps it’s not that people can’t meet the minimum balance requirements of traditional banks. But there’s a certain sense that you’re working for the bank when you have to meet a threshold to open the account or worse, being penalized with a fee when you don’t.
Is a mobile app really that important in choosing a bank? For some, it may be the most important thing.
According to a 2018 survey, 51% of millennials would switch banks just for a better app. And online banks have developed banking apps that resonate with customers. SoFi, Chime, and Varo all have mobile apps that customers rate at 4.8 stars on Apple’s App Store. And none of the online banks fall below 4.7 stars.
While the megabanks, like Chase and Bank of America, have also excelled with their mobile banking apps, regional and smaller banks haven’t fared as well. And it’s the smaller banks’ loss of customers that has fueled much of the growth in digital banks.
Elimination of “Gotcha” Fees
There are fees and then there are fees.
When it comes to fees that create an adversarial relationship between a bank and a customer, the NSF fee has to top the list. Citibank, for instance, charges $34 for an “insufficient funds” or “returned check” fee.
And that’s pretty typical. All told, banks charged about $30 billion in overdraft fees in 2020.
Online banks typically charge no overdraft fees. Many just block transactions that would cause the account to go negative, preventing the accidental overdraft. That’s the approach taken by Dave.
Ally, on the other hand, still allows customers’ balances to go negative but provides six days for customers to make up the difference–fee-free.
Chime takes it a step further. It offers customers its SpotMe feature–allowing customers to borrow small amounts to cover shortfalls with no fees.
Disadvantages of Online Banks
Sure, online banks have been innovative. But the primary advantages of online banks come from the absence of branches and the resulting cost savings that allow them to offer fewer (or lower) fees and richer benefits.
As for disadvantages? They come from the same key difference.
This one pretty much comes down to your preference and comfort level with technology. Do you need, or just want, a physical branch to conduct routine banking?
My parents are good examples. Banking to them still, for the most part, means going to the bank. It’s mostly the technological obstacles. Sure, they can surf the internet and use a smartphone, more or less. But there’s a habit or comfort level or whatever that will still have them drive to a bank to deposit a check.
They’re not alone. According to the FDIC, 21% of households with a bank account still conducted their banking with a teller. If you’re in that group, online banks won’t be a good fit.
Not too many of us regularly deposit cash in our checking or savings accounts anymore. It’s even unusual in the service industry to get cash tips these days. But, if you find yourself regularly depositing cash, online banks present some challenges.
If you think about how you make cash deposits with a traditional bank, you have two options– go to the branch or drop it in one of your bank’s ATMs. Neither option exists with online banks. They don’t have branches, and they don’t own ATMs.
So what’s the solution? Well, for some online banks, like Ally, there isn’t one–at least not a direct one. Ally Bank doesn’t take cash deposits at all.
Others, like Chime or Dave use third-party networks, like Green Dot, to receive cash deposits at retail locations. That gets the cash into your account. But it comes with a fee–charged by the third-party network, not by Chime or Dave.
For individuals, check payments are going extinct. The Federal Reserve reports the number at 7% of consumer payments. Still, there’s that 7%.
Online banks that offer checking accounts–more accurately (and more often) called spending accounts, provide online bill pay services that allow account holders to pay by paper check for those vendors or people that require it. But those checks are issued directly from the bank.
As for getting a checkbook, many online banks don’t offer it. So, if you still need to physically write checks, you may need to consider a traditional bank.
There are still some odds and ends that online banks don’t offer that traditional banks do.
Wire transfers, for instance. When you buy or sell a house, money still moves by wire transfer. (Yeah, it seems a bit archaic to me too). None of the neobanks–like Chime, Dave, or N26, offer incoming wire transfers. And most don’t offer outgoing wires, although SoFi is one of the exceptions.
Some of the online-only banks, specifically those that are chartered banks (rather than neobanks), handle wire transfers. Ally, for example, falls into this group. For those that offer wires, fees are comparable to traditional banks.
Other services that require a branch, or more accurately, a person–like notary services–aren’t going to be offered by online banks either.
Online Banks, Traditional Banks, or a Combination of Both
So, online bank or traditional, brick and mortar?
The cheapest and higher-yield route points to online banks. And the technology–mobile apps and portals–tends to favor the online banks as well or at least is on par with the best brick and mortar technology offered by the megabanks.
From the consumer banking perspective, it’s frankly hard to make much of a case for brick and mortar. But then there are those couple of key exceptions–like cash deposits or wires–that make traditional banks a requirement.
The choice between online banks and brick and mortar may actually be a false one. According to one survey, half of Americans have accounts at more than one bank. That’s where I live. I have some real estate investments so I have to periodically make those wire transfers. And I still have individual contractors working on those properties that have to be paid quickly and can’t take electronic payments. In other words, paper checks. That means I need a traditional bank account. But most of my banking, and all of my cash savings, are handled through an online bank account. Money can be transferred between accounts easily and pretty quickly (1-3 days). For me, it works well.
Absent those few needs for a traditional bank account, online banks can provide a complete, and often more lucrative, replacement for the brick and mortar alternatives.