Why Are Savings Account Rates So Low?

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When I first started The Simple Dollar in late 2006, it was pretty easy to find a savings account that offered a 4% annual return on your deposits. Some banks, such as HSBC Direct, were offering introductory rates as high as 6% annually.

In other words, if you deposited $1,000 into an account at HSBC Direct at that time, it paid you $5 a month.

Rates like these were competitive with the long term returns one might expect from the stock market. It actually made good sense from a long-term investment standpoint to have at least some of your money in savings. Savings accounts are incredibly liquid, virtually risk free, and they were getting 4-6% annual returns? That’s a pretty good investment choice right there.

Today, you’re extremely hard-pressed to find a savings account that offers better than 1.5%. Some banks offer higher rates, but they’re tied to specific savings requirements, minimum balances, usage requirements, and other factors.

What happened? Why did savings accounts go from having very nice returns to having tiny returns? And will those higher rates ever return?

How Banks Set Savings Account Rates
To understand this story, you have to understand why banks offer savings accounts to begin with and how they decide what rates to offer.

For the most part, a bank can offer whatever rate they want on a savings account. If one bank decided to suddenly start offering a 5% return on savings accounts, they certainly could do so.

The only problem is that it would be a really bad business idea. Banks want some deposits in their savings accounts, but unless they can lend out money at a higher rate than they are offering on savings accounts, they’re not going to make money. They’re going to lose money.

For example, let’s take a look at home mortgages. Right now, you can pretty easily get a home mortgage at 4 to 5% interest. In order to lend you that money, banks have to have that money (technically, they have to have a portion of that money because they can count the mortage payments they’re going to receive… but that’s a whole different issue) in their vaults. In order to have that money, they have to have people depositing their money into that bank, and in order to get that, they have to offer some return on that deposit. At the same time, they have to offer less of a return on that deposit than they’re able to make from mortgages. So, the rate they offer has to be somewhere above 0%, but somewhere well below the 3-4% they get on mortgages.

Thus, we have interest rates on savings accounts hovering around 1%.

Five years ago, we lived in a different situation. Fixed rate home mortgages were much higher then – 7 to 8% interest rates were typical. At the same time, banks were making a lot of home loans. Remember that housing bubble of the late 2000s? Yeah, that’s what we’re talking about.

In order to be able to make those loans, banks legally needed at least some of that money in their vaults, so they cranked up the returns they offered on savings accounts to get some money into their vaults. Thus, you often saw interest rates on savings accounts inching up into the 4% range.

The Federal Reserve’s Role
Now, these rates aren’t set entirely by magic. Our old friend the Federal Reserve plays a role in all of this. The Federal Reserve bank has the ability to loan money to banks at a certain rate, known as the Federal Discount Rate. They also control another rate, called the Federal Funds Rate, which is the rate at which banks can lend money to each other. The Federal Funds Rate is usually a little lower than the Federal Discount Rate because, ideally, banks will loan money to each other. When you hear about the Federal Reserve “printing money,” it basically means that they’re making new money available to banks because they won’t (or can’t) lend to each other.

The way the economy usually works is that when the economy slows down, the Federal Reserve lowers these two interest rates so that it’s very easy for banks to lend money to each other and borrow from the government and thus easy for banks to offer low interest loans to businesses that want to get started. This causes the economy to pick back up.

At the same time, when the economy is roaring along, the Federal Reserve usually raises those rates over time to control inflation. If they kept the rates constantly low, banks would continually request new money from the Federal Reserve, and adding new money to the economy means that every existing dollar is worth a little less. In other words, it’s the dreaded inflation.

So, right now, the economy is weak. The Federal Reserve has the rates about as low as they can go so that, once companies start spending and borrowing again, it’s as easy as possible for the banks to lend them money at a very inexpensive rate.

It’s because of these low Federal Reserve rates that mortgages are so low right now. Banks can get money from the Federal Reserve to cover mortgages at 0.75% and they essentially sell them at around 4%, keeping the difference as their profit.

It makes no sense, when they can get money from the Fed at 0.75%, to offer much more than that on a savings account. They’d be absolutely silly to offer anything close to what the mortgage rates are, too. The only reason they might offer a little bit more than they could get from the Federal Reserve is because they’re required to keep some money in their vaults if they want to lend out money.

As a result, you’re seeing interest rates on savings accounts at around 1% or so.

Will This Ever Change?
Unless you’re an extreme economic pessimist, the answer is yes. We will eventually see the Federal Reserve raise their rates again as the economy gets rolling again.

When that happens, mortgage rates will go up. You’ll also see some people tempted to take their money out of savings accounts because the economy is doing well again. They’ll want to buy stuff (because consumer confidence is high) or invest it in stocks (because the stock market will have been doing very well at that point).

To keep the money in their vaults, banks will want to raise interest rates. They won’t raise them as high as mortgage rates, but they’ll compete a bit with each other because the more they have in their vaults, the more they can lend, and the banks want to lend. It’s how they make money.

What Should I Do With My Savings Account Money?
If you have money in a savings account and are reading this article, you’re probably disappointed in the 1% (or so) return you’re getting lately. Surely you can do better than that?

Your best option is probably to simply pay off debts if you have any. Almost all of your debts should have an interest rate much higher than 1%, which means you’ll get a much better return on your dollar by making an early debt payment. The only catch is that you won’t actually see that dollar again until the loan is paid off. Paying off debt essentially locks up your dollars and you don’t see the returns until your debt disappears early.

Other options that allow you to still be able to access your money have other problems. If they’re stable investments, they’re usually pegged in some way to those Federal Reserve rates above, meaning you’re not going to get a great return. If they’re risky investments – well, you’re taking on a risk that you’re going to lose some of your balance.

In my eyes, paying off debt is the best choice as long as you keep a healthy emergency fund in a stable, easy-to-access savings account. If you don’t have any debt, start exploring other investments at your own discretion, but still keep an emergency fund.

Good luck!

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18 thoughts on “Why Are Savings Account Rates So Low?

  1. i have an acct with captial one that pays over 1%. good rate but i dont like there tv adds featuring george castanzas father and his caustic voice. the worst part is where he says ‘call me’ to the woman at the end of the add. kinda creepy and unnecessary. what does that have to do with savings accts?

  2. I’ve never understood why the interest rates track the way they do with the economy. To me it would make more sense to have the interest rates high in a down economy to encourage savings so as to get the money into the hands of the producers and get more things made and people employed, and then when it’s booming and there are many goods and services on the market, make it easier to borrow so that people can buy them.

  3. Embrace risk, at least until the Fed threatens to raise rates.

    Take $10k and open a broker margin account. Buy 1000 shares of AGNC (yield 18+%). That will give you a net yield of about 32% after margin interest and fees.

  4. AGNC is in the family of mortgage REITs. CYS, HTS, IVR, NLY, & TWO are similar.

    NLY is probably the most popular, however, for 28% more yield, I like AGNC.

  5. FYI, for Canadians, there’s a new account offered from a Manitoba credit union that anyone outside of Quebec can ebank with. They are offering 2.5% on Savings Accounts with no drawbacks that I can see. ING is 1.5% and Ally is 2.0%.

    I’d link but will be stuck in moderation hell.

  6. @Paul: The economy works by people and businesses spending money. The money that is in a savings account doesn’t get spent, therefore cannot be used to buy raw materials, pay a worker and produce something. Rates go down so that people will spend money so businesses will make things so people will buy things so people can be employed so they can spend money to buy things…and so on and so on. Money sitting in a bank account is bad for a consumer economy (like ours). If you have an economy that based less on people buying things but more on companies producing things (like China), then rates are not such a big deal. People can still save, but since what the employed people are making is not being used IN the country, saving isn’t as devastating.

    Once the economy starts growing again, the Fed raises rates to keep people from spending – it’s economics 101. The price of a good is what the market will pay. If 10 people are willing to pay $1 for something and it sells out, the manufacturer can say, what if I go to $1.10? Wouldn’t you? The whole idea is to maximize profit. If you have 10 people willing to pay $1 but then you have 50 people willing to pay $1.10, isn’t that better? Well..bam! You have inflation. Inflation isn’t a bad thing all the time – it’s what drives the economy. Inflation of 2-3% per year is a good thing. Why? Because psychologically, you know that if you don’t buy it now, next year, it will cost just a bit more. And you don’t want to part with it. So you buy it now. But in a year from now, MORE people will want to buy it, so prices go up, just a bit.

    Raising rates will cause people to rethink spending. “If I save this now, what can I buy in a year?” If you have $1 and get paid 4% interest, then you will have $1.04 next year. But if prices only go up 2%, you’ve made out. However, if rates are too low, inflation starts to get out of hand. People start spending like crazy and businesses keep raising prices. Eventually, a loaf of bread costs $8 (because people are willing to pay it!).

    Eventually, the market can bear no more and consumers stop spending. In order to sell products, business have to lower prices. Some people will buy bread at $6. Others will wait. So prices come down more. Now more people jump in at $5. But still more people wait. Now it’s $4. Then $3. If done right, when the price reaches the ‘right’ price, businesses will be making a profit, and the market will bear the price.

    But sometimes..the price is still too high. People keep waiting and waiting for prices to come down. That is deflation, which is very difficult to break. Interest rates can only go so low. This is the problem we’re in today. You can’t force people to spend. So businesses, instead of hiring, start firing. Start offshoring. They still need to produce a profit. Since revenue isn’t going up, costs need to come down. But then the laid off workers don’t spend. So businesses have to lay off more people..and the cycle keeps going downward until something changes it. The only force that’s strong enough to change it..is government.

    Deflation is a much more dangerous animal. And we (globally) are still very much on that brink. Recession and depression are merely other words for deflation.

    I could keep going, but this comment has become long enough. This was not meant to be all for you all Paul (although it started off that way). Hopefully it’s opened some eyes.

    Ironically, this comment is on a blog that preaches frugality – which is exact opposite of what the government wants you (as a consumer) to do. Oh the irony. :-)

  7. I get the government theory, but the intuitive fact is that you have to produce a good before someone consumes it. It’s not like we have warehouses full of stuff with people waiting to buy. Rather, we have people desperate for stuff who can’t get it.

    But even if that doesn’t hold, I still don’t get why in a boom the fed would try to curtail the boom instead of running it as high as we can to try to get the investment to make real advances and get new products.

  8. “Rather, we have people desperate for stuff who can’t get it.”

    We do? To the extent that this is true, it’s because the people don’t have any money.

  9. Somewhere I read or heard recently that the banks were making up for previous losses by giving savers a lower interest rate. Could anyone elaborate on this?

  10. “In my eyes, paying off debt is the best choice as long as you keep a healthy emergency fund in a stable, easy-to-access savings account.” True. Unless you’ve run out of debt to pay off. (Woo hoo!)

    Then you’re like the non-smokers who can supposedly improve their health by stopping smoking–in order to stop, you have to start, and that can’t be good.

  11. Trent, great article; you explained the situation beautifully!

    Yes, we can move away from savings accounts to earn a higher return; however, we give up two things: stability and liquidity. Due to the risk / return ratio, the more you risk, the higher your potential return, but as you clearly stated, the value may go down, such as investing in the stock market. If you can wait it out, great. But, you may need the money NOW, and you can’t wait for the value to go back up, if it ever does. So much for liquidity.

    Very good point about paying off your debt: if your credit card is charging you 20% interest, by paying it off, you’ll receive a 20% tax-free return. However, as you also stated, you need an emergency fund.

    You should be funding your emergency fund at the same time you’re paying off your debt. Without an emergency fund if the car needs new tires, guess what? So much for that debt you paid off. Your emergency fund needs to be LIQUID so you can access it at any time because emergencies occur at any time.

    I suggest that 15% of your gross income go towards paying off your debt and your emergency fund.

    How much should your emergency fund be? To cover expenses for the number of months it would take you to find a job if you lost your current one. Once you’ve paid off your debt and your emergency fund is adequate, THEN you can invest that 15% for retirement.

  12. People need to realize that the either need to trade risk or time for that higher rate. It’s going to be this way for a while, and the longer they wait for those rates to rise, the more time they’ve wasted that they could have been in a better type of investment.

  13. #11 – This is my rudimentary & possibly flawed understanding: When banks have to borrow money, they have to pay interest on it just like we do; money banks have invested earns interest. And, with people defaulting on home loans/credit cards/other loans, that’s money the bank has paid out but not getting back. To make up losses, banks reduce the interest they pay to customers to below the rate the banks earn on their investments & keep the difference.

  14. A small quiz:

    There are three bank accounts that each have 0% real (after inflation) yield. Which one would you you for saving?

    A) 8.0% yield.
    B) 0.0% yield.
    C) 1.58% yield.

  15. @Macke,
    Is this a trick question? If the real after-inflation yield is zero on all three accounts, then of course the 0.0% yield account is the best, since the government has still not figured out how to tax zero. The other two accounts will earn taxable income, causing a net loss of wealth after inflation and taxes.

  16. There are other factors at play in low savings account rates.

    For one, I believe the premium banks pay to the FDIC for coverage increased in 2008/2009. FDIC stands for Federal Deposit INSURANCE Corporation, and it charges a premium for its protection. Moreover, the increase in maximum account size and extension of similar protection to money market accounts must have come with some premium attached. Along with that, I believe bank capital reserve requirements have been increased.

    Another, and possibly the major reason, is that banks are having a hard time finding anyone to lend to. A lot of the lending of past years has slowed down to a trickle – new home construction, commercial real estate development, equipment leaing, business start-ups, are all at a standstill.

    Five years ago, if you put $1,000 into a savings account, the bank had to keep X% in reserve, pay Y% in FDIC premiums, and then could easily lend the rest at 8% to a commercial developer, so it wanted to attract more money and was willing to pay a higher rate for it. Today, the reserve is X+x%, the premium is Y+y%, and there’s no commercial developer wanting to borrow the money who can realistically expect to pay it back. About the only value that money has to the bank right now is to make it look stronger on paper to prop its stock value up and keep its staff employed.

    With inflation at rates well above the yield on savings accounts, here are some alterative investments I’m making, that I’m confident will earn a much higher rate of return:

    1. Shelf-stable food and household supplies purchased on sale. Food and commodity prices have been steadily rising, and are likely to do so for the foreseeable future. $1 today will buy me two extra cans of tuna on sale. If I put that dollar in a savings account at .25% interest, next year I’d have $1.0025 that will buy me only a can and a half of tuna on sale. If I buy the two cans of tuna today and put them on my shelf, a year from now I’ll have two cans of tuna. I haven’t made any money, but I haven’t lost it.

    2. Firewood. Last year I bought a cord of firewood for $200 and used about half of it over the winter to supplement my electric heat during the coldest months. My electricity bill for the winter was $168 lower than the previous year despite a colder winter AND the house was warmer and more comfortable. My firewood supplier is charging $225 for a cord this year and warns of more hikes to come due to higher gas prices and regulatory fees. If I’d bought an extra cord last year with $200 of what I had in my savings account, I would have earned a $25 return instead of 25 cents.

    3. Tools. As I’ve started doing more home repairs myself, I’ve realized the value of quality tools. If having the right tool allows me to avoid hiring someone else to do a service, it’s an excellent investment that will beat both inflation in the price of the tool and inflation in the price of the service.

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