Why Do Banks Pay Interest on Savings Accounts?
Learn the fundamental reasons banks pay interest on savings, exploring their operational model, market dynamics, and broader economic influences.
A savings account is a deposit account held at a bank or other financial institution that provides a secure place for funds while earning a small amount of interest. Interest represents the compensation paid by the bank to you for the use of your money. This article explains why banks pay interest on savings accounts.
How Banks Profit from Deposits
Banks operate by taking in deposits from customers and then lending out a portion of those funds to other customers, businesses, or governments. Financial intermediation is the core of their business model. When you deposit money into a savings account, the bank does not simply hold that cash in a vault; instead, it uses part of it to fund various loans, such as mortgages, auto loans, or business loans.
The primary way banks generate revenue is through the “net interest margin” (NIM). This margin is the difference between the interest income banks earn on the loans they issue and the interest expense they pay out to depositors. For instance, a bank might pay a depositor 0.5% interest on their savings account while charging a borrower 5% interest on a car loan, with the difference forming the bank’s profit.
This lending activity is enabled because banks are only required to hold a fraction of their customers’ deposits in reserve. The remaining portion is available for lending. While the Federal Reserve eliminated reserve requirements for all depository institutions in March 2020, banks still manage their liquidity to ensure they can meet withdrawal demands.
The Impact of Competition on Interest
Banks operate in a competitive environment, where they vie for customer deposits. Attracting and retaining these deposits is important for banks, as deposits serve as a low-cost funding source for their lending activities. To secure these funds, banks must offer competitive interest rates on savings accounts.
If a bank offers lower interest rates than its competitors, it risks losing depositors and their funds. This market pressure encourages banks to adjust their rates to remain attractive to savers. Different types of financial institutions, such as large traditional banks versus smaller online-only banks, may offer varying rates due to differences in overhead costs and operational strategies. Online banks, for example, often have lower operating expenses, allowing them to offer higher interest rates on savings products.
Factors Influencing Interest Rates
The interest rates banks offer on savings accounts are influenced by broader economic conditions and policy decisions. A factor is the monetary policy set by the Federal Reserve, particularly the federal funds rate. This rate affects what banks charge each other for overnight loans, influencing their overall cost of funds.
When the Federal Reserve raises the federal funds rate, it leads to higher interest rates on loans and, consequently, higher interest rates on savings accounts. Conversely, a decrease in the federal funds rate results in lower savings account rates. Inflation also plays a role; if inflation is high, central banks may raise interest rates to help control rising prices, which can lead to higher savings rates. Economic growth and the overall demand for credit also influence interest rates, with strong economic periods often seeing higher rates due to increased borrowing activity. Finally, a bank’s own liquidity needs can affect the rates it offers to attract or retain deposits.