Online banks typically offer higher interest rates than their brick-and-mortar counterparts. Since they do not have the same overhead as traditional banks (fewer employees to pay, no branches to maintain, lower utility bills and so on), they can afford to pay higher interest on savings.
The above is also true for certificates of deposit (CDs), but to a far lesser extent. Short-term CDs often carry half or even less the interest you’ll find on an online savings account, even though savings are less liquid. Why are online savings account rates so much better than CDs?
Deposit Rates are Low — Blame the Fed
The Federal Reserve hasn’t been the most popular bunch in recent years for a plethora of reasons. A number of complaints have surfaced with growing intensity, namely involving its quasi-public status (it’s a collection of private bankers – major conflict of interest), its ability to increase the federal debt with little or no oversight and, of course, its performance.
For you, the saver, the Fed just got a bit more evil. Why? According to Andrew Schrage, co-owner of Money Crashers Personal Finance, “The Federal Reserve has kept interest rates at nearly 0% for some time now, which means that banks can borrow money virtually free of charge. This means that they have little motivation to offer a high interest rate for depositors.”
Banks make money by lending it at higher interest rates than they borrow it for. In other words, they offer account holders like you a certain interest rate to borrow your money and then lend it for more interest than they pay you. But since banks currently borrow money nearly interest-free, depositors earn even less.
Online Savings Account vs. CD Rates
There is very little risk to either type of account; both online CDs and savings accounts are FDIC-insured up to $250,000 per depositor, per institution, and cannot lose principal.
However, the logic behind why online CD rates are lower than online savings rates is simple: you’re sacrificing a potentially higher yield for a guaranteed rate.
According to Schrage, “The only reason one may opt for a certificate of deposit over an online savings account is that the interest rate is locked in on a CD for the term of the investment. Online savings account interest rates are variable, and can go up or down as the bank chooses.”
Andrea Puchalsky, Director of Global Communications for Ally Bank, echoed Schrage, stating, “Rates for our online savings and money market accounts are variable and may change after the account is opened, whereas the shorter term CD rates are fixed for the length of the CD term.”
In other words, some depositors would rather accept a lower, guaranteed level of interest than a higher, variable rate. Think of this in terms of investing in general, where some opt for aggressive investments, such as stocks, that have the potential to make a fortune or completely bottom out. Others select conservative investments, such as bonds, which provide a more stable, albeit lower, return. Those who select a certificate of deposit likely want to earn some interest without worrying about rate decreases.
Is an Online CD or Savings Account Better for Your Bottom Line?
At present, most savings accounts are superior to short-term CDs at online banks. You’ll earn more interest and have full liquidity, meaning you can take the money out at any time.
With long-term CDs, the issue boils down to how much you value earnings versus liquidity. Generally, at terms of around 12 months or more, online banks offer higher rates on CDs than savings accounts. But the difference is fairly minimal (typically tenths of a percent), which means you’d have to dump a lot of money into such an account to earn materially more from a CD.
Online banks, while offering the top savings rates around, offer low returns these days. Unfortunately, their CDs pay out even less, given the lack of interest rate risk involved. But among financial institutions, the best online banks are offering some of the most competitive rates.
Most savers will do better in an online savings account at present due to their superior liquidity and rates versus short-term CDs. Longer-term CDs may be worthwhile for those who are comfortable with setting a portion of their wealth aside for a fixed period, given their higher interest rates. Speak with a financial professional before deciding which option is best for you.
Photo credit: Ken Teegardin