Why Do Savings Accounts at Your Bank Earn Interest?

Savings accounts provide a mechanism for individuals to safeguard their money while also earning a return on their deposited funds. This return, known as interest, represents a payment from the financial institution to the account holder for the use of their money. The concept of interest allows deposited funds to gradually increase over time, offering a benefit to savers.

The Bank’s Core Function: Using Deposits for Lending

Banks operate as financial intermediaries, connecting those with surplus funds to those who need to borrow. They generate their primary revenue by lending money at a higher interest rate than they pay to their depositors. Deposits from savings accounts are a significant source of these funds, forming the capital base that banks extend as loans for purposes like mortgages, business investments, and personal financing.

The interest paid to savings account holders is the cost a bank incurs to acquire these funds. The difference between the interest rate a bank earns on its loans and the interest rate it pays on its deposits is known as the interest rate spread. This spread represents the bank’s profit margin on its lending operations.

Attracting and retaining deposits is crucial for a bank’s stability and profitability. By offering interest, banks incentivize individuals to place their money into savings accounts, ensuring a consistent supply of funds for lending. Without a robust deposit base, a bank would have limited capacity to issue loans, impacting its ability to generate revenue. This model highlights the symbiotic relationship between depositors and financial institutions.

Factors Influencing Interest Rates

Several economic and market forces influence the interest rates banks offer on savings accounts. The Federal Reserve’s monetary policy plays a significant role, particularly its actions regarding the federal funds rate. When the Federal Reserve raises this benchmark rate, it typically leads to an increase in interest rates across the economy, including those on savings accounts.

Inflation also affects the real return on savings, influencing banks’ decisions on interest rates. If inflation is high, the purchasing power of money decreases over time, meaning savers need a higher nominal interest rate to maintain the real value of their deposits. Banks consider these inflationary pressures when setting their rates to attract and retain depositors. Broader economic conditions, such as economic growth and employment levels, can also impact the demand for loans, which influences the rates banks pay for deposits.

Competition among financial institutions is another important factor. Banks compete for deposits by offering competitive interest rates, which can drive rates up, especially for high-yield savings accounts. The type of account also matters, with certificates of deposit (CDs) often offering higher rates than standard savings accounts in exchange for a commitment to keep funds deposited for a fixed term. These varied influences combine to determine the interest rate a saver receives.

How Interest Accrues and is Paid

Interest on savings accounts typically accrues through compound interest. This means interest is earned not only on the initial principal balance but also on any previously accumulated interest. This compounding effect allows the account balance to grow at an accelerating rate over time.

Banks generally calculate interest based on the average daily balance of the account. This method involves summing the end-of-day balances for each day and then dividing by the number of days. The calculated interest is typically credited to the account monthly or quarterly, depending on the bank’s policy.

Changes in the account balance, such as deposits or withdrawals, directly impact the total interest earned. A higher average daily balance results in more interest, while frequent withdrawals can reduce the amount accrued. Understanding these calculation methods allows account holders to better estimate their potential earnings.