It‘s easy to know how banks determine interest rates on savings accounts. The cost of borrowing is shown in the form of interest. When you lend money, you can collect interest. And this is what happens when you ‘lend your money to the bank’ via a savings account.
Technically, the bank is borrowing the money you have saved in them. In return, they pay you interest.
How do banks set interest rates on savings accounts?
Banks set interest rates on the money you lend to them in three forms as follows:
1. Simple Interest
The banks set interest rates on savings accounts based on the amount of the original deposit. If you don’t add or lessen your principal balance, banks will calculate your interest based on it.
It means even if you earn an amount over time, the simple interest will only work on the principal balance and will not account for the earned interests.
For instance, you have $500 in your account, which accrues a 1% interest rate each month. At the end of the month, you’d have $505 in your account. You’d have $510 in the second month because the principal balance of $500 will only be the one to earn an interest each month.
2. Compound Interest
Unlike simple interest, compound interest considers the earned interest together with the principal balance when calculating interest.
Depending on the savings account provider, the calculation of interest earned each day may be yearly, monthly, or daily.
This method allows you to grow your savings faster over time.
3. Future Value
Here, the banks set interest on your money at a future time. This works when you constantly add periodic balances to your account so that the bank can calculate interest rates continuously on your added savings and the already-paid interest.
How do banks calculate interest rates on savings accounts?
Banks calculate interest on a savings account by using this formula:
Interest = P x R x N
The original balance or beginning balance is the principal amount (P), while the yearly interest rate expressed as a decimal is the (R). As for (N), it represents the one-year time period.
For instance, the banks have a yearly interest rate of 1%, and you have $20,000 in your savings account.
Interest = $20,000 x 0.01 x 1 will give you an interest of $200.
How Do Banks Determine Interest Rates on Savings Accounts
Although the banks determine the rates, the general level of rates in the economy also affects how interest rates are determined. Some of the factors are as follows:
Government Influence on Interest Rates
For safe returns, banks invest in Treasuries. When the government buys many new US Treasuries, it can lower yields and bid up the price of Treasuries. As a result, banks will also charge lower interest rates on loans and savings accounts.
This means savings account rates will drop when the interest rates of other returns decline and vice versa.
Supply and Demand of Savings Accounts
The supply and demand of savings account also affect interest rates. Banks can increase interest rates on savings accounts to encourage people.
On the other hand, they offer lower rates if banks want to decrease bank debits, making savings account less attractive to consumers.
Who decides the interest rates on savings account?
As mentioned, banks decide on the interest rates on a savings account. The Central Banks in the US use a centralized banking model that considers and ensures stable liquidity and prices.
The policy prevents a significant drop in prices that could affect interest rates by routinely checking the supply of money within the economy.
Where can I find higher interest rates on savings account?
Nationally, 0.08% is the national average for a savings account. However, you can still find higher interest rates on the list of Investopedia’s top savings account rates:
- 1.65% APY – First Foundation Bank
- 1.61% APY – Bask Bank
- 1.51% APY – UFB Direct
- 1.50% APY – Ivy Bank
- 1.40% APY – E*Trade
- 1.30% APY – iGobanking and CFG Bank
- 1.27% APY – CIBC USA
- 1.26% APY – LendingClub and TAB Bank
- 1.25% APY – Citizens Access, Fitness Bank, My Banking Direct, and Quontic Bank
- 1.20% APY – Rising Bank
- 1.15% APY – Bread Savings and Brio Direct
Alternatives to Savings Accounts
You may also want to consider the following alternatives to let your money earn interest:
Certificates of Deposit (CDs)
The interest rate in a CD is fixed, and it only accrues until the selected withdrawal date. It can range for as long as years or as short as one to five months.
The best thing about it is that the interest rates on CDs are higher than traditional savings accounts.
Money Market Accounts
This alternative also offers a higher interest rate besides limited checking account services. However, you must maintain a minimum balance or pay a minimum opening deposit amount. You may have to pay penalty fees when this goes below the required balance.
Mutual Funds and ETFs
Mutual funds and ETFs are liquid funds wherein you can have a 6% to 6.5% return after all the costs. This average return is much higher than bank savings.
These savings are also one of the safest investments because they focus on corporate and short-term US government debts.
Takeaway FAQs for the article:
Who decides the interest rates on savings accounts?
The banks decide on the interest rate on savings accounts after considering all the external factors that may affect how they set interest rates.
How much interest will I get on $1000 a year in a savings account?
You can use the formula above to calculate the simple interest. But for compound interest, use this formula: A = P(1+r/n)nt
The total amount you want to find is A, your principal amount is P, and the interest rate in decimal form is r. The number of months your bank compounds is n, while the interest earned per year is t.
A = 1,000(1+ 0.01/12)(12 X 1)
You could earn a total amount of $1,010.05, which means the interest you made is $10.05.