Current bank rates are something that everyone is interested in. Whether you’re trying to build up that savings account or cut down on your mortgage payments, bank rates play an integral part in just about every financial aspect of your life.
Does anyone actually know what makes these rates rise and fall? How do banks actually come up with the numbers that dictate how much you’re getting paid for your money or how much interest is building up against your loan?
Contrary to what you might think, these numbers aren’t created arbitrarily by some suits in a back office lighting cigars with dollar bills.
There is actually a very intricate system in place that affects what a bank determines is a justified rate to offer. Justified, of course, is what is most profitable for their institution.
The Fed Rates
There is one main component to how bank rates are determined, and that is the U.S. Federal Reserve, which determines the monetary policies of the country’s economy. The Fed dictates the amount of money flowing into the nation’s financial system by raising and lowering interest rates, similar to turning water on and off like a faucet–hence the term liquidity.
Their goal is to maintain a balance that prevents inflation (dollar value goes down) or deflation (asset values go down). There are two interest rates that have a direct impact on what banks pay you for your deposit accounts:
Federal Funds Rate: This is what banks charge each other to borrow funds overnight. Though banks determine how much they actually charge each other, it usually doesn’t stray too far from the federal funds rate.
Discount Rate: This interest rate is what the Fed charges banks to directly borrow funds from it to meet their reserve requirement. It is usually higher than the federal funds rate because the Federal Reserve wants to serve only as a last-resort for banks that need access to capital.
When the economy is slow like it is now, the Fed will generally lower rates to provide more money into the financial system. The idea is that increasing the money flowing into the economy will make it easier for banks to lend to businesses and consumers.
This also makes it more practical to spend rather than save because interest rates aren’t as attractive. In the same token, it’s also better to borrow because interest rates are low. The opposite is true when the economy is booming.
The Federal Reserve will actually raise rates to entice consumers to save, and make it harder to borrow.
Deposit Account Interest Rates
For all intents and purposes, banks make money by borrowing funds from someone and lending that same money to someone else at a higher interest rate. So when a bank lets you store your money with them, they aren’t doing you a favor.
The reason you’re getting paid interest in your savings account is because you’re lending the institution your money so that they can turn around and lend it to your neighbor at a higher clip.
However, banks have a choice about where to borrow their own money. They can loan money they have from your deposit account, or they can borrow money from other banks, at a cost, to lend to their customers.
When the federal funds rate is low, it makes it easier for banks to borrow from one another. This means there is less demand for your dollar, so the interest rates you earn are lower.
In essence, when the Fed lowers interest rates, it makes less sense for savers to keep their money in deposit accounts. This stimulates economic activity because it makes spending or investing in other assets like stocks or commodities more attractive than letting your dollars collect dust.
When the economy is active, the Federal Reserve will raise rates as an incentive for consumers to save some of the money being thrown around.
Which Accounts Earn More?
Not all bank accounts are created equal. Here is a breakdown of why some accounts provide more bang for your buck:
- Transactional accounts: These include checking and debit accounts or any accounts that involve frequent access to funds. These accounts earn the lowest amount of interest because they require banks to keep a reserve of money in case customers need to access them.
- Savings/money market accounts: These accounts pay higher interest rates than the transactional variety because they aren’t as easy to access. While you can still make withdrawals, there is a monthly limit (usually six) to how many times you can access the funds.
- Time deposits: Most commonly, certificates of deposit pay the highest interest because customers are locked in for a fixed period. Banks don’t have to worry about making the funds available until the maturation date, otherwise they can charge a hefty fee if customers want to redeem early.
- Online savings accounts: These accounts often have interest rates that rival those of CDs because they remove the administration costs of traditional savings accounts.
Other factors come into play, such as the length of time and the amount of money you’re depositing with the bank. As a general rule of thumb, banks will pay higher yields for more of both.
Another thing to keep in mind is what’s good for savers is almost always bad for borrowers, and vice versa. When interest rates are low, banks are able to lend money at a lower cost. This is most likely why mortgage rates are at very low levels right now.
The only problem is that since the recession began, lending institutions have increased requirements for borrowing eligibility. While the Fed rates are appealing, the main factors of trying to get a loan right now include:
- Default risk: This means your credit score and payment history. Banks will charge higher rates on someone more likely to default on their loan.
- Economic activity: Lending institutions will also keep an eye on the risk of inflation. They don’t want to lend you money that will be worth less when they get it back without factoring that in the price. Usually, the price of U.S. treasuries and bonds will dictate the direction of lending rates.
- Time horizon: The sooner the bank gets its money back, the more they can do with it and the less risk they’re exposed to.
When Will Bank Rates Increase?
It is hard to tell when the Federal Reserve will deem it appropriate to raise rates again. Being that the economy is still sluggish, it is hard to imagine rates will be raised any time soon. That doesn’t mean it is a bad time to save, however.
Though interest rates remain low, banks are actively searching for new deposits to strengthen their assets and stability. In addition, you can take advantage of short-term CDs that pay the best interest rates on the market. There is a lot of uncertainty in other asset markets like stocks as well, so it is a good idea to keep your money liquid and flexible.
How have you been dealing with these low interest rates? Are you keeping your money safe in a CD or being adventurous with other investments?