How the interest rate affects your savings account
Bank / Savings Account
If you have a savings account, you’re likely getting a barely noticeable return of 0.06% interest, which is the national average, according to the FDIC. That’s a far cry from 1980, at the height of the so-called Great Inflation, when three-month CD yields approached 20%. In fact, savings accounts have provided 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 highs for months — the almighty interest rate.
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Interest is the fee you pay to borrow money or the payment you get when you lend it. It is calculated as a percentage of the principal, called the rate. You may notice that you have many interest rates in your financial life, such as:
- A mortgage
- A car loan
- A student loan
- Credit card
- A payday loan
The other side of the coin is the interest you earn for lending money to the bank, which is what you do when you deposit money in a savings account. That’s almost certain to be the lowest interest rate of your entire financial life – unless you have an interest check, which pays even less than six hundredths of a percent.
In short, banks have all the money because they charge high interest rates for the money they lend and pay low interest rates on the money they borrow.
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All of these different rates associated with all of these different types of loans are based on a single rate 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 the FOMC wants to reduce the money supply, it raises the interest rate to discourage borrowing and attract deposits. When he wants to increase the money supply, he lowers the rates. The federal funds rate determines the prime rate, which is the lowest rate that banks charge other banks for overnight loans.
When the FOMC increases the federal funds rate, the prime rate increases. When the prime rate rises, interest rates on loans – and, in theory, deposits in savings accounts – rise with it. When the FOMC lowers the rate, it becomes cheaper to borrow money, but the return you collect in your savings account decreases.
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Your savings account is based on the money-growing power of compound interest, allowing you to earn interest on the interest your original money has already earned. One month’s interest 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 more 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 1% interest. 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 you earned from the bank for lending it the money as a deposit .
As Discover points out, 0.01% interest — what you’ll get with the worst savings accounts — would earn you 50 cents on a $5,000 deposit over the course of a year. The same deposit in the same year with an interest rate of 1%, on the other hand, would earn you $50.53.
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The trade-off with interest is that when rates go up, you pay more to borrow money, but earn more from savings vehicles like CDs, money market accounts, and savings accounts — in theory. . In reality, the FOMC is not the only force pushing interest rates up or down. Individual lenders have wide discretion and routinely charge different borrowers different rates based on their credit history and all sorts of other factors.
They also determine what they’re willing to pay for deposits — and while your savings account’s APY should go up when the FOMC raises its own rate, that doesn’t always happen. You might notice, for example, that last year’s record mortgage rates rose slightly when interest rates rose, but your savings account held firm no matter how sad it was. pays you.
Indeed, the financial sector is not immune to the laws of supply and demand.
According to Credit Karma, banks currently have so much cash that they simply don’t need your deposits enough to pay more. Therefore, unlike in 1980, it is a banking market that allows lenders to charge more for loans when the prime rate rises without increasing the APY they pay into their savings accounts.
So for now, plan for your emergency fund to keep losing money to inflation while you “save” money in an account that earns you six hundredths more than what you he would win if you stuff him under your mattress.
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