When I first started investing, I signed up for a premium brokerage called Scottrade. I chose them because they had the lowest trade commissions out of all of their competitors. They were a solid brokerage and I loved their platform. They were eventually bought out by TD Ameritrade and that’s where a lot of money still sits.
Since then, I have learned about several apps and brokerages that offer 0% commissions. I joined 3 of these brokerages because I liked different aspects of each of them but one question kept coming up in my head. How do free investment apps make money? I mean commissions are the only fees I used to pay to a brokerage. Nothing’s really free, right?
So I started to do a lot of research about this and its actually a lot simpler than you would imagine. The first thing I want to make sure you understand is that there is no “shady business” going on here and they aren’t “pulling a fast one over on you.” The 0% commission model is effective for these companies due to a few key principles that they have mastered.
Brokerages Make Money on Interest
When you open an account, the first thing you do is deposit money. You link a debit card or authorize direct access from your bank account to the brokerage. You put your money in and then you wait. What is this wait for? Well, for starters, you need to decide what you want to invest in. Maybe you signed up for a brokerage with the intent to buy 100 shares of Facebook Stock. Most people don’t do this though.
Investing money in the right asset takes a lot of consideration most of the time and while you are waiting for the perfect stock to invest in and the perfect time, your money collects dust in the brokerage account. This is not necessarily a bad thing! You want to make the right decision. That’s fine. While you are making that decision though, the brokerage will benefit from the money that is sitting in your account. This goes for paid brokerage too!
Let’s say, a brokerage has 1 million investors that have each deposited $50. Now let’s say on average, an investor buys stock with this $50 and has $3 left over in their account because they didn’t have enough to buy one more share. That would be $3,000,000 that the brokerage is earning interest on daily! It’s only $3 for you but that adds up pretty quickly.
The Mystical Order Flow Fees
This is actually something that happens behind the scene for all brokerages and you have no idea. Let’s say you order 100 shares of a stock, the brokerage will send the trade to another third party known as a market maker.
The Market Maker is who aligns buyers to sellers at the exchange. When a buyer buys shares and a seller sells shares, there is a small difference in price known as the bid ask spread. The Market Maker will benefit off these small differences which can be a few pennies per share to even a fraction of a penny per share.
They do this on a huge scale though all throughout the day and this is how their firm makes money. Market Makers are necessary for keeping the market fluid though and allowing you to make trades effortlessly and quickly. The Market Maker’s firm pays the brokerage for referring the trade usually a tiny amount per trade but all these fees add up and help the brokerage account make a profit.
Margin Accounts Come With Fees
Have you ever taken a loan or bought something on credit? Almost everyone has. Buying on credit allows you to have access to something now that you would normally have to wait a long time to purchase. Brokerages offer a similar service known as Margin Accounts.
Margin Accounts allow you to borrow money from a brokerage in order to make an investment. How much you are allowed to borrow and how much you will pay in margin fees depends on the brokerage. When you do this, you are trading on margin.
I found that the average full featured big name brokerages have around a 9.50% annual margin fee for margin balance up to $10,000. So let’s run an example on how this might work. Try to stay with me! Let’s say you want to make a stock trade. You have $3,000 but want to borrow an additional $3,000 so you can make this trade using $6,000 total. You buy the stock on margin and hold it in your account for 2 months. Then you sell stock and your margin balance goes back down to $0. How much would you pay in fees?
$3000 x 0.095 (9.5%) = $285/year.
You only kept it for 2 months though so:
Take $285 and divide it by 360. Most brokerages calculate daily margin by dividing by 360 rather than 365 due to simplicity.
$285 / 360 = $0.79.
Then multiply it by the days you had it in use which we’ll say is 61 days (assuming a month with 30 days and a month with 31).
$0.79 x 61 = $48.29.
So to borrow that $3000 would have cost you almost $50 for two months. Why do this though? That seems expensive! Let’s say the stock you bought went up 10% in the amount of time you held it. You would have made not only $3000 x 0.10 = $300 but you would have made an additional $300 on margin as well giving you a total earning of $600.
That’s the power of margin. Of course if it went down, you would have lost twice as much too while using someone else’s money but that’s a discussion for another article.
Now often times, these free commission brokerages offer very appealing margin rates as well. For example Webull offers margin up to $25,000 for 6.99% which is drastically lower than the industry average. Robinhood offers a monthly fee based service along with margin rates. They offer a premium service known as Robinhood Gold that charges $5/mo to use up to $1000 in margin and then any amount over $1000 is charged 5% annually.
So the next question you should be asking yourself is how do these discount brokerages afford to not only charge $0 in commissions, but also much lower rates in margin interest?
If you look at companies like Ally Financial and TD Ameritrade, their corporate footprint is massive. Ally has over 8,000 employees and TD Ameritrade has over 9,000 employees. They also have a lot of brick and mortar locations where they provide financial services to their clients and prospective clients. They have a huge advertising budget and offer many services in addition to being a brokerage for stocks.
Robinhood for example has less than 500 employees and operates its entire business online. They do not need to buy or lease properties all across the United States like bigger companies do.
Zero Commission Brokers are laser focused on keeping their overhead light so they can provide better service to their customers at a much more competitive rate.
Viral Marketing Brings In Their Customers
When was the last time you saw an ad for Matador, Webull or Robinhood? They’re around but they do not plaster media outlets like the bigger companies do. This is because they have found an audience that loves to get things for free. I’m talking of Millennials of course (myself included).
Millennial are notorious for their internet savvy approach to research. They know their way around a computer better than all previous generations combined and spread content via social networks at an incredible rate. Robinhood, Webull and Matador are just a few examples of companies that have capitalized on this approach and kept their advertising budget at a reasonable level.
All of these apps encourage sharability to spread the word of their growing enterprise. If you share your link with a friend, you both get a free stock! Sound familiar? This is an incredible way to incentivize people to not only talk about investing with others but to also share who they invest through as well.
Are Free Investment Apps Inferior
Most of the time when we hear something is cheaper, we automatically think they must be inferior. As I showed though, the reason these services cost less is because they have a different and leaner business plan that takes advantage of technology that is available and reduces its need for traditional business expenses. It is easier to reduce the burden on the customer by having fewer employees and less real estate.
That being said, there is obviously going to be a trade off. Full Service Brokerages offer more services than just stock and ETF trading. Some of these have mutual funds that obviously come with mutual fund managers, financial advisers, retirement savings accounts, bonds, college funds and more. If you want to have all of your money attached to an account that can do all of those things, free investment apps are not for you.
If you want to enjoy the benefit of zero commission trades and reduced margin interest rates and leave the other stuff to another account, that is completely possible too.
For me, I use all of these. I have the majority of my holdings in TD Ameritrade because I’ve been with them the longest and have a lot of long term holdings in there. There hasn’t been a reason for me to sell my securities just to move them somewhere else.
Any time I put more money into securities though, I add to either my Robinhood, Webull, or Matador account. I could just choose one of these three but I find them all useful in different ways. If I was going to choose only one of the three though, I’d probably choose either Robinhood or Webull.
Robinhood is what I use mostly for Options and Crypto Investing since these are available on Robinhood and not Webull or Matador.
Webull has the best tools (with no competition) for screening and analyzing stocks. For that reason and the ease of placing stock orders in conjunction to research, I like Webull for new stock trades that I’m getting into.
Matador is more of a social network for trading stocks and I have a few friends that I communicate with through the app. If I’m making a trade that I want to talk about with them, I’ll choose Matador but this is a small account that I don’t really use often.
Hopefully you have a better understanding now of how these free investment apps make money. Like I said earlier, they aren’t doing anything “shady” or taking your money in other ways. They simply make money off interest from unsettled funds that are sitting in your account, margin interest on money that you borrow from the brokerage, and order flow fees.
Major brokerages use these same vehicles to make money as well but they also charge commissions in order to generate a lot more revenue to cover the many other costs associated with having a much larger business.
Thank you for reading this article. If you found it useful or have a question, I’d love to hear from you below. If someone you know could benefit from this information, please share this with them as well.
Until next time, let’s start investing!
Eric Baglio has been investing for over ten years and learned a lot of valuable lessons along the way. He has helped numerous people start investing on their own and founded Let’s Start Investing to help anyone willing to learn how to build wealth. His favorite brokerage is Webull and his favorite stock advising service is Motley Fool Stock Advisor.