How the Interest Rate Affects Your Savings Account
If you have a savings account, you’re probably eking out a barely noticeable yield of 0.06% interest, which is the national average, according to the FDIC. That’s far cry from 1980 at the peak of the so-called Great Inflation, when yields on three-month CDs were approaching 20%. In fact, savings accounts have delivered such paltry returns for so long that they were losing money to rising prices long before inflation took off in 2021.
Why? For the same reason that mortgages have been at or near record lows for months on end — the all-powerful interest rate.
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Interest Rates Determine What the Bank Charges You and What You Charge the Bank
Interest is the fee that you pay to borrow money or the payment you collect when you loan it. It’s calculated as a percentage of the principal, called the rate. You might notice that you have many interest rates in your financial life, such as:
A mortgage
A car loan
A student loan
Credit cards
A payday loan
On the flip side of the coin is the interest that you collect for loaning money to the bank, which you do when you deposit money into a savings account. That’s almost certain to be the lowest interest rate in your entire financial life — unless you have interest checking, which pays even less than six one-hundredths of a percent.
In short, banks have all the money because they charge high interest rates for the money they loan and pay low interest rates on the money they borrow.
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Who Sets Interest Rates?
All those different rates associated with all those different kinds of loans are based on a single rate that’s set by a group of 12 bankers and monetary policymakers who make up the Federal Open Market Committee (FOMC).
The FOMC meets several times a year to determine what the federal funds rate should be. When FOMC wants to reduce the supply of money, it will raise the interest rate to deter borrowing and attract deposits. When it wants to increase the money supply, it will lower rates. The federal funds rate determines the prime rate, which is the lowest rate that banks charge other banks for overnight loans.
When FOMC raises the federal funds rate, the prime rate goes up. When the prime rate goes up, interest rates for loans — and, in theory, savings account deposits — go up right along with it. When FOMC lowers the rate, it becomes cheaper to borrow money, but the yield you collect from your savings account goes down.
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Higher Interest Rates Mean More Money in Your Savings Account
Your savings account is based on the money-growing power of compound interest, which lets you earn interest on the interest that your original money already earned. The interest from one month is added to your balance, and that sum earns even more interest the next month, and so on.
You can use an investment calculator from Investor.gov to see how your savings account will grow larger than the sum of your contributions over time.
Let’s say you started with an initial investment of $1,000 and contributed $100 per month for 10 years at an interest rate of 1%. After a decade, you would have contributed $13,000, but you would have $13,725.25 in your savings account — the difference comes from the interest that you collected from the bank for lending it money in the form of a deposit.
As Discover points out, 0.01% interest — which is what you’ll get with the worst savings accounts — would earn you 50 cents on a $5,000 deposit over the course of one year. The same deposit in the same year with a 1% interest rate, on the other hand, would earn you $50.53.
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So, When FOMC Raises Rates, Savings Accounts Pay Higher Yields?
The tradeoff with interest is that when rates rise, you pay more to borrow money but you earn more from savings vehicles like CDs, money market accounts and savings accounts — in theory. In reality, the FOMC is not the only force that drives interest rates up or down. Individual lenders have wide discretion and routinely charge different borrowers different rates based on their credit history and all kinds of other factors.
They also determine what they’re willing to pay for deposits — and although your savings account APY should rise when the FOMC raises its own rate, that doesn’t always happen. You might notice, for example, that last year’s record-low mortgage rates ticked up a little when interest rates rose, but your savings account held fast at whatever sad rate it’s paying you.
That’s because the financial industry is not immune to the laws of supply and demand.
According to Credit Karma, banks are currently so flush with cash that they simply don’t need your deposits badly enough to pay more for them. Therefore, unlike 1980, it’s a banker’s market that allows lenders to charge more for loans when the prime rate rises without increasing the APY they pay on their savings accounts.
So for now, plan for your emergency fund to continue losing money to inflation while you “save” cash in an account that pays you six one-hundredths of a percent more than it would earn if you stuffed it under your mattress.
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This article originally appeared on GOBankingRates.com: How the Interest Rate Affects Your Savings Account
