How Online Banks Work

Online banks offer many of the same services provided by traditional banks -- and sometimes a few more.

One of the first questions that consumers have about online-only banks is how to deposit a physical check. The preferred method for most online banks is to scan the check on both sides and upload the check image to the bank's Web site. Some online banks even let you snap a pic of your check with a smartphone app and make a deposit on the go. Depending on your online bank, the funds will be available in your account the same day or the next business day. If you don't have a scanner or a fancy smartphone, most online banks also provide customers with free pre-paid envelopes to mail in checks for deposit.

Online banks also offer direct deposit and free incoming wire transfers to make deposits electronically.

Checking accounts and savings accounts are standard at online banks. Even better, most offer free checking with no minimum balance. A number of online banks offer interest-bearing checking accounts, something that isn't standard at brick-and-mortar banks or is reserved for customers with high balances. As of November 2011, the best interest rate for a traditional checking account is 0.10 percent with a $500 minimum balance, while rates on some online checking accounts are as high as 0.85 percent with a $1 minimum balance [source: Google Advisor]. Debit cards are also standard for online checking accounts.

It's free and easy to transfer money between separate online banking accounts, and free to send money to other customers of the same online bank. Some banks even offer free person-to-person money transfers, even if the recipient isn't an online bank customer. All you need is the person's name, their email address, the bank name and the last four digits of their bank account number [source: ING Direct].

A few online banks offer loans, mortgages and automobile financing. Ally Bank, one of the largest US-based online banks, used to be GMAC, and is still one of the most popular backers of auto loans for US carmakers. Several online banks also offer investment services. The most common are certificates of deposit (CDs), money market accounts, and Roth IRAs and IRA CDs.

Now let's look at a few of the top advantages for choosing an online bank over a brick-and-mortar institution.

The biggest benefit of choosing an online bank over a more traditional bank with physical branch locations comes down to saving money. It's common for a traditional bank to charge for checking accounts, ordering physical checks, or for failure to maintain a minimum account balance. It's also common for banks to charge customers a fee for using an ATM at another bank. In contrast, most online banks don't charge any fees at all.

Online banks are able to charge less for banking services because they have fewer expenses to cover. Think of the costs associated with running a large chain of bank branches: the cost of buying or renting the land, constructing the building, employee salaries, utilities, the list goes on. Because most online banking services are provided by a roomful of servers and an outsourced customer service staff, there is much less overhead [source: Roberts]. And some of those savings can be passed along to customers.

For example, most online checking accounts are free, with free checks and no minimum account balance. Several online banks offer 100 percent free ATM services at any ATM in America. Any fees that you are charged by another bank are reimbursed with your monthly bank statement.

Another benefit of online banking is higher interest rates on checking accounts, savings accounts and investment products like CDs and money market accounts [source: Bomberger]. In this case, the differences can be significant. As mentioned on the previous page, the rate for a $1 minimum balance online checking account is eight times higher than a traditional checking account with a $500 minimum balance.

Security is a major concern with online banking. According to the 2010 Global Online Consumer Security Survey by security firm RSA, 86 percent of respondents said they were "very concerned" or "somewhat concerned" about having their personal information stolen or misused while banking online [source: RSA]. Although losses related to online banking fraud have decreased significantly over the past five years, it still costs consumers tens of millions of dollars a year in countries like the U.K. and U.S. [source: Kirk].

Phishing scams are one of the most popular methods of committing online banking fraud. The classic phishing scam consists of an e-mail that looks like it's from your bank, complete with logos and graphics. In the e-mail, your online bank says that your account will be terminated unless you click on a link and confirm your account information and personal information like your date of birth and Social Security number. Criminals can then use this highly sensitive information to access your real bank account or apply for credit cards in your name. Recently, Chase.com posted an example of a phishing scam that used a phony pop-up window where users are asked to enter their account information [source: Chase].

The best protection against phishing scams is the knowledge that your bank will never e-mail you and request your personal information or account information. They already have that information on file. If you ever receive a questionable e-mail, the best advice is to call your bank's customer service line and see if the message is legit.

Another concern with online banking is the financial integrity of the bank itself. Is this a fly-by-night operation or a stable, well-financed institution? For peace of mind, make sure that you work only with online banks that are insured by the FDIC [source: Bomberger]. The FDIC was established in 1933 to protect depositors in the case of a bank failure. The typical FDIC insurance policy guarantees up to $250,000 in deposits for each individual [source: FDIC].

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