How do banks set interest rates? If you keep your money in a bank it's important to know what drives bank interest rates. Rates change depending on what's happening in the world at large, and every bank does things differently.
Bank Rates and the Economy
Economic conditions are the most important factor in bank interest rates. Whether you earn a lot or a little depends on rates in the world as a whole. For the most part, bank interest rates follow other rates. When rates “out there” are low, you won’t earn much on your savings at the bank; when interest rates in general rise, bank rates will follow.
Rates are lowest during slow economic times. There is not much demand for money, so you aren’t rewarded for handing it over to your bank. There’s not a line of customers beating on the bank’s door asking for loans. The bank is happy to take your money, but they can’t do much with it, so they pay you a low rate.
For more details, see how interest rates work in general.
Different Bank, Different Rate
Most bank interest rates are around the same level, but there will certainly be differences. Some banks pay more than others for the same product (like savings accounts, for example). It’s not uncommon to find a difference of 1% APY or more between banks, and that can add up.
Why are some bank interest rates higher than others? Banks raise rates when they want to gather money. If they need to get deposits in the door, a high rate on savings accounts will attract money. If, on the other hand, they don’t need cash, they can keep rates lower.
Banks have different approaches to earning money. Some take deposits and lend them out, while others take a more varied approach (earning revenue and fees from other services like credit cards and ancillary business). Depending on the economy -- possibly the local economy for small banks and credit unions -- you’ll find that the “borrowing and lending” banks change rates as their customers’ needs change.
Organizational structure is also important. Some banks have shareholders demanding that the bank grow (and/or share income with the shareholders), and it’s hard for those banks to pay high rates to depositors. However, some banks are able to keep only what they need to pay the bills, and share the rest of the revenue (from loans, ATM fees, etc) with account holders. Small banks and credit unions are most likely to fit the latter model.
Getting Better Bank Interest Rates
What can you do to get the best rates? If rates in general are low, you can’t do much to change the economy -- but you can search out rates at the higher end of the range of rates available.
First, figure out whether or not it’s worth your time to chase higher bank interest rates. Most people do not need the highest rate out there (or even a top-ten-percentile rate). Do the math and find out how much you’ll earn if you have to switch banks, and remember that your money might be “idle” -- not earning interest -- while you move it around.
- Run some numbers with a Compound Interest Calculator
- Traditional big banks
- Smaller community banks
- Online banks
- Credit unions
If you find yourself looking at institutions you’re not familiar with, be sure that they’re FDIC insured (or NCUSIF insured if it’s a credit union). It is possible to earn more by taking on additional risk, but that may not be what you’re interested in.