Why Savings Account Interest Rates Are So Low


In 2006, I started writing about personal finance. One of the first topics I wrote about was the online high-yield savings account. (See also: The Best 5 Online Savings Accounts)

Back then, these accounts were all the rage. I opened an account offering 5% APY and wrote about how great online accounts were for emergency fund purposes. A deposit of $1,000 meant a little more than $4 in interest the first month.

Now, you'd be hard-pressed to find a high-yield account offering much more than 1% APY, providing you with right around 83 cents in interest the first month. That's a big difference.

But why are interest rates so low on savings accounts? Shouldn't we want to encourage savers in our current economy?

Depositors vs. Borrowers

In reality, banks can pay whatever yield they want on a savings account. If a bank wanted to start paying 5%, it could. There's nothing stopping it, except the desire to turn a profit.

Banks set yields on deposits based on the rate they can get for lending money. The difference between what a bank receives on mortgages and auto loans and other credit, and what the bank pays out in yields to depositors, represents one of the bank's revenue streams.

In 2007, when I bought my home, the best interest rate available to me was 6.02%. By then, the yield on my savings account had dropped to 4%. Now, you can get a mortgage for right around 3.50%. As long as a bank is able to lend at a rate higher than what it pays to depositors, there's a better chance of profit.

So why even pay depositors at all? The reason is that banks are required to keep some capital in their reserves. They are required to keep money in — for lack of a better word — the vault in order to lend. For the most part, credits and debits appear on paper and digitally. But those records have to show that the bank has money in reserve.

Hence the need for depositors.

Banks need to attract depositors to put money in the bank, so they have something to lend (or something to leverage). A bank pays a yield in order to encourage you to park your money in an account; the bank then lends the money at a higher rate than it pays you.

The Federal Reserve and Savings Account Rates

So why are mortgage (and other loan) rates so low? What sets those rates?

The Federal Reserve plays a large role in determining what the rates look like. There are two main rates that come into play:

  • Federal Discount Rate: This is the rate at which the Federal Reserve lends money to the banks.
  • Federal Funds Rate: This is the rate we're all familiar with when the news talks about the Fed "setting rates." This is the rate at which banks can lend money to each other.

The Federal Reserve prefers banks to lend to each other, rather than borrow from the Fed, so the Federal Funds Rate is often a little lower than the Discount Rate.

Since consumer spending drives about 70% of economic activity in our country, the ability of banks to lend to each other, and to consumers, to keep the money going 'round the economy is a big part of what the Federal Reserve does.

Lower Fed Rates Encourage Borrowing

In times of economic turmoil and difficulty, the Fed lowers the two rates in order to encourage borrowing. Right now, the Fed Discount Rate is at 0.75%, and the Fed Funds Rate is operating in a target range of between 0% and 0.25%.

In a down economy, with so much of the activity dependent on consumer spending, the goal is to attract consumers to loans. These low Fed rates bring loan rates down. Since banks can borrow from the Fed, and from each other, at such low rates, it means they can lend to consumers at lower rates, encouraging them to borrow.

Fed Purchases of Treasuries Reduce Mortgage Rates

Another twist is the fact that the Federal Reserve is still buying long-term Treasury securities. The rates on long-term Treasury securities often influence mortgage rates. As long as the Fed maintains its monthly bond purchase program, long-term Treasury rates are expected to remain somewhat low, keeping mortgage rates down with them.

Of course, once the banks are no longer enjoying higher rates of return on the money they lend, it means they no longer pay their depositors a truly high yield.

When Will Savings Account Rates Go Up?

Following the last policy meeting for the Federal Open Market Committee (FOMC), the body that sets interest rate policy, Federal Reserve Chair Ben Bernanke announced that interest rates will remain ultra-low until 2015. The bond purchases will continue for now, but they are likely to be reduced as a prelude to an interest rate hike from the Fed.

No one knows for sure when the Fed will decide to hike rates. The FOMC makes its decisions based on how members feel the economy is faring. If the economy is heating up, the Fed raises interest rates in order to slow inflation and keep growth in check.

As the economy improves, interest rates are more likely to rise. There isn't the need to encourage banks and consumers to borrow, so rates are allowed to rise. Once the interest rates on loans begin rising, the yields on savings accounts are likely to begin rising as well.

Until then, consumers are stuck looking for yield in places other than savings accounts. Many are turning to the stock market, since all of these efforts at economic stimulus are aimed at helping businesses borrow at lower rates (and boost their profits). However, there are larger risks with stocks than with cash held in a bank insured by the FDIC.

If you have debt, though, now is a good time to aggressively tackle it. With interest rates lower, more of your payment goes to principal. And paying off high-interest debt will offer you a better return on your money than watching it languish in a savings account.

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Guest's picture

Bond yields are super low for the same reasons. Many of them aren't keeping up with inflation. It's rough for seniors, who are more heavily invested in bonds!

Guest's picture

Thank you for this article, it was really interesting and I learned a lot!

Guest's picture

Nice one. I think the interet rates are determined by the current interest rate and the banking operations thus making them low.

The Family CEO's picture

I agree it seems like the low interest rates are here to stay, at least for a while. While I love my 3% mortgage, it certainly makes it frustrating to be a saver.

Guest's picture

The government will certainly leave interest rates low through the next election, to buy the votes necessary to keep the Dems in power. (not that the Republicans would have done differently). Alas, I can see political parties buying elections for the forseeable future, until the U.S.A. goes the way of the Roman empire. I'll vote Libertarian until then, thank you. I never thought I'd see the story of 'The Little Red Hen' come true....

Guest's picture

The people with savings accounts need to cash out of the banks and sit on their cash. With the banks having all the people remove their cash they would be forced to raising the interest rates! Lets get moving people....... Pass this on and lets get those rates up!

Guest's picture

I'm very disappointed in the low savings rate. For me personally, at this time, as long as rates remain low I will stay thrifty and spend little discretionary money. And I'm way to worried to take what little money I do have and 'invest' it.

Guest's picture

Some community banks and credit unions have high interest checking accounts, offering around 2 to 3% interest which they max out after 10k to 25k. There are hoops you have to jump through like making 10-15 debit card transactions a month, signing up for electronic statements, having a direct deposit or debit each month. They are usually FDIC or NCUA insured, so it's a nice alternative to the market and typical savings accounts.

Guest's picture

If people start taking their money out of these banks the rates will go up really fast. Look at what they charge on credit cards, but they think we should just keep our money in their establishment for basically nothing. Take your money out and go to a credit union...send them a message!!

Guest's picture

Credit Unions pay no better interest rate then Banks. At least years ago US Savings Bonds were great you could double your income every 7 years or so. You would think with the Government hurting so bad they would bring those savings bonds back.
It seems when Reagan signed the Gramm-Rudman Laws not only lowering interest but also taking away the interest deductions on taxes it was the beginning of the end.

Guest's picture

Older people depend on and need their savings account interest to supplement their income and when they spend it,it helps the economy. But of course with the help of our government, only the Wall St. thieves end up with it.

Banks have plenty of money and many other accounts to pay interest savings from.
Payment shouldn't have to depend on what the personal borrowing and lending market do.


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