What is a neobank, and how does it work?

Digital banking has evolved significantly since the 2008 recession, with neobanks leading the charge. These financial technology (fintech) companies offer innovative digital experiences and consumer-friendly features that traditional banks often lack.

While their popularity continues to grow, it’s important to understand that neobanks operate under different regulations than traditional banks, which can affect how they protect your money.

What is a neobank?

A neobank is a financial technology (fintech) company that offers banking services digitally through digital platforms or apps. Without physical branches, neobanks can often operate with lower costs than traditional banks. This often translates to customer benefits like higher interest rates and lower fees.

While these companies offer banking services, they are not actually banks. Instead, they partner with real banks to bring those services. This distinction matters because federal regulations don’t oversee neobanks the same way they monitor traditional banks.

You may recognize popular neobanks like Chime, Aspiration, and Current. Some companies, including SoFi and Varo Bank, have taken the extra step to become actual banks by getting bank charters.

Another unique feature of neobanks is that many look beyond traditional credit scores when approving customers for financial products. This approach often makes their services more accessible to people who might face rejection from traditional banks.

How neobanks work

Banking partnerships

While neobanks pride themselves on innovation and technological advancement, they rely on partnerships with federally-regulated banking giants to provide their services. When you open a checking or savings account with a neobank, a larger bank usually holds your money behind the scenes.

That’s good news for your money. While neobanks don’t usually carry FDIC insurance — their partner banks do. Since your money sits with the partner bank, it should remain protected. However, there’s one last caveat: FDIC insurance only covers bank failures. The protection becomes less clear if the neobank encounters problems, and you might face delays accessing your funds.

It’s a roundabout setup, so you should always check the fine print before storing your money with a neobank. Changes may be coming to how regulators oversee neobanks. In 2023, the Consumer Financial Protection Bureau proposed new rules to regulate “nonbank companies” — particularly those handling more than $5 million in yearly transactions — similarly to traditional banks.

Common features

Neobanks distinguish themselves with several characteristic features:

• Sophisticated, user-friendly digital platforms
• Online-only banking services
• Convenient perks like early direct deposit
• Minimal or zero account fees
• Competitive savings account interest rates
• Often more flexible credit card approval processes

Pros and cons of using a neobank

Neobanks tend to appeal to tech lovers and those looking for more flexibility than traditional banks. That said, they have limitations and aren’t for everyone.

Benefits

• Lower fees: The digital-only model helps neobanks reduce operating costs, allowing them to minimize account fees.
• Higher interest rates: These cost savings often translate to better yields on savings accounts.
• Modern experience: Because neobanks often operate exclusively digitally, the mobile app and online experience are often superior to traditional banks.
• Accessibility: Many neobanks have eliminated credit checks or security deposits for their credit cards.
• Quick account opening: Many neobanks offer streamlined application processes that take minutes rather than days.
• Advanced budgeting tools: Many provide built-in features to track spending, set savings goals, and manage your money more effectively.

Drawbacks

• Limited product selection: Unlike traditional banks offering comprehensive services (home and auto loans, credit cards, various accounts), neobanks typically provide only basic accounts and perhaps a credit card.
• No physical locations: When dealing with a complex financial situation, you might prefer to visit a bank branch in person. However, neobanks support often comes only through chat or email, which may not suit everyone.
• Less regulation: Current regulatory standards for neobanks differ from traditional banks, potentially increasing risk.
• Cash deposit challenges: Without physical locations, depositing cash can be more complicated, depending on the neobank.

Is your money safe in a neobank?

As mentioned, neobanks don’t carry FDIC insurance themselves, but their partner banks protect funds through their FDIC coverage.

“If you're using a neobank, make sure they partner with an FDIC-insured institution and understand their deposit protection,” advises Alyson Basso, a certified financial planner. “Without that guarantee, your deposits won’t have the same level of safety as in a traditional bank.”

Remember that FDIC insurance only kicks in if the partner bank fails. A neobank’s failure wouldn’t trigger FDIC protection. In theory, your cash should remain safe with the partner bank, but you may experience difficulties with neobank-managed features, like the mobile app or customer service.

Popular neobanks

If you’re interested in a neobank, you’ve probably encountered these companies.

• Chime: Launched in 2012, Chime partners with three FDIC-insured banks to offer credit cards, peer-to-peer payments, and checking and savings accounts. It’s known for its green branding and no-credit-check policy for credit cards.
• Aspiration: This mission-based neobank combines banking with climate activism, offering various accounts backed by five FDIC-insured banks.
• Varo Bank: Originally a neobank, Varo obtained its bank charter in 2020, becoming a full-fledged online bank with FDIC insurance and expanded services, including checking and savings accounts, credit cards, and even personal loans.

Who should consider a neobank?

Neobanks appeal particularly to tech-savvy customers looking for alternatives to the fees and low savings yields that come with most traditional banks. Before choosing a neobank, look out for a few things:

• FDIC insurance: Confirm the neobank’s partnership with an FDIC-insured bank.
• ATM access: Most neobanks won’t have dedicated ATMs but may waive ATM fees or partner with ATM networks so customers can easily access their cash. Research their ATM network partnerships and fee policies, including international access if you travel.
• Interest rates and fees: Not all neobanks are fee-free and offer the highest interest rates. Compare their offerings with traditional banks to ensure better value, including any hidden charges.
• Available products: Check out the neobank’s full product lineup. If you know you’ll be on the market for a credit card soon after opening a savings account, it may be convenient to open all accounts with the same neobank.
• Special features: Look for unique benefits like early direct deposit or flexible credit requirements that may be useful for you.
• Customer feedback: Check recent customer experiences and common issues, particularly regarding customer service.

Frequently asked questions

The bottom line

Neobanks represent an innovative approach to digital banking, offering modern services through partnerships with established banks. People tend to gravitate toward neobanks for their excellent digital experiences, low fees, high rates on savings accounts, and flexible features like early paycheck access.

But before moving your money to a neobank, verify FDIC insurance coverage through their partner banks and read the fine print on key features like interest rates, fees, ATM access, and available services.