How Are Savings Account Interest Rates Determined?


May 17, 2019

When you’re shopping around for a new savings account or a certificate of deposit, chances are that you’re looking for a competitive interest rate. But have you ever wondered just how the financial institution decides what rates to offer?

The truth of it is, there are several factors that influence the interest rates on deposit accounts. The first factor is the financial product itself. For example, savings accounts and money market accounts typically offer lower interest rates than a CD. This largely has to do with the level of access you have to your money. With savings and money market accounts you can typically make a certain number of withdrawals without penalty, while a CD requires you to leave your money with the bank for a specified period of time. Generally, the longer the term of your CD, the higher the interest rate you’ll receive. Think of it like this – the bank rewards you for leaving your money with them for a set amount of time. The longer you agree to leave the money there, the more likely you are to receive an attractive rate.

Of course, interest rates will vary by financial institution. Many online-only banks offer higher interest rates on their deposit accounts than their brick-and-mortar counterparts because they have less overhead costs to deal with. Because they’re not paying money to maintain and staff physical branches, they can pass that cost-savings along to their customers in the way of more competitive interest rates. Likewise, many brick-and-mortar banks offer “online-only” accounts with more attractive interest rates than their regular deposit products. The customer is expected to handle their banking needs online (and in some cases they’ll even be charged a fee if they need to visit a branch), and in return they receive a higher interest rate on their account.

Another factor in how banks determine the interest rates for savings products is supply and demand. The money that customers deposit into their bank accounts is the same money that the financial institution lends out to borrowers, who pay interest on the loans. So, if the demand for loans increases, and the bank needs more deposits from which to lend, they may be inclined to increase the interest rates on their deposit accounts to make them more attractive to savers like you. On the flip side, a decreased demand for loans could result in lower interest rates on savings accounts, because the bank doesn’t need as many deposits to keep up with lending demands.

It’s also typical for banks to base their deposit account rates on “benchmark” interest rates. The federal funds rate is the rate that financial institutions charge each other for extremely short-term loans. This federal funds rate is a common benchmark for the interest rates that banks offer their customers. In other words, if the federal funds rate changes, banks will typically adjust the rates they’re offering customers on savings products like savings accounts and CDs.

Investor demand for U.S. Treasury bonds and notes is another factor, as is the Federal Reserve, which sets the federal funds rate. The Federal Reserve (often referred to simply as “the Fed”) frequently makes announcements and decisions about how monetary policy will impact rates.

The Fed influences these rates by buying or selling previously issued U.S. securities. When it buys more securities, banks end up with more money than they can use for lending, and the interest rates decrease. And when the Fed sells securities, money from the banks is tapped, resulting in fewer funds available for lending. This, in turn, forces a hike in interest rates.

Knowing which factors affect the interest rates on deposit accounts can help you to make a more informed decision when you’re shopping around for a savings product. And don’t forget to review and factor in any fees or maintenance charges associated with the account before you open it – those can take a real bite out of your earned interest if you’re not careful!

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