Why Do Savings Accounts Have Interest?

A savings account provides a secure place to store funds while allowing them to grow over time. Financial institutions pay interest on these deposits as a fundamental part of their business operations. This interest represents a return to the account holder for allowing the bank to use their money.

The Bank’s Role in Generating Interest

Banks function as financial intermediaries, connecting individuals who have surplus money with those who need to borrow. When you deposit money into a savings account, the bank does not simply store it in a vault. Instead, these deposited funds become part of a larger pool of capital that the bank uses for its primary activities. Banks lend out a significant portion of these deposits to other customers in the form of various loans.

The interest charged on these loans is higher than the interest rate paid to depositors, creating a “spread” which is a primary source of bank revenue. This difference covers the bank’s operating costs, potential loan defaults, and generates profit. Banks also invest a portion of deposited funds in low-risk securities, which provide steady returns. Therefore, the interest paid on savings accounts is essentially the cost banks incur to attract and retain the deposits necessary to fund their lending and investment activities.

Understanding Interest Calculation

Interest on savings accounts is calculated using one of two methods: simple interest or compound interest. Simple interest is computed only on the original principal amount deposited. The interest earned remains constant, assuming no additional deposits or withdrawals. For example, a $1,000 deposit earning 1% simple interest would yield $10 each year.

Most savings accounts use compound interest, allowing earnings to grow more over time. Compound interest is calculated on both the initial principal and any accumulated interest from previous periods. This creates a “snowball effect,” where money earns interest on itself, leading to accelerated growth. The frequency of compounding, such as daily, monthly, or quarterly, impacts the total interest earned, with more frequent compounding leading to greater returns.

What Influences Interest Rates

Several factors influence the interest rates banks offer on savings accounts. A primary influence is the Federal Reserve’s monetary policy, particularly its target rate. This is the rate at which banks lend money to each other overnight, and changes to it ripple throughout the economy, affecting consumer interest rates. When the Federal Reserve raises this benchmark rate, banks often increase the rates they pay on deposits to attract funds, and conversely, rates tend to fall when the Fed lowers its target.

Inflation also plays a role, as banks and consumers consider the purchasing power of money over time. If inflation is high, the real value of savings decreases unless the interest rate earned keeps pace. Banks may offer higher rates during inflationary periods to provide a better return to depositors. The overall economic climate, including loan demand and economic growth, influences rates; strong loan demand may encourage banks to offer more competitive rates to secure deposits. Competition among financial institutions also drives interest rate offerings, with online banks often providing higher yields due to lower operating costs compared to traditional brick-and-mortar banks.