Why do banks pay interest?
February 26, 2013
Q: With interest rates on some savings accounts getting down near zero these days, it raises a question: Do savings accounts have to pay an interest rate at all? Why are there interest rates in the first place?
A: That's a good fundamental finance question, and perhaps it has never been more relevant than in today's low-interest-rate environment. According to the FDIC, as of mid-February the average rate on U.S. savings accounts was down to 0.07 percent -- certainly well in sight of zero interest.
The fact is, savings accounts don't have to pay you any interest. From one perspective, they already aren't, since inflation has exceeded savings account interest rates over the past few years. To answer the question of whether savings account rates could go to zero on an absolute basis, it helps to start with a look at why there are interest rates to begin with, and why the current environment might cause some of those rates to disappear.
Why is there interest to begin with?
When you deposit money in a bank, it doesn't stay locked in a vault gathering dust. The bank has the ability to use that money to make loans or investments. Essentially, you are lending money to the bank.
Whenever one party loans money to another, it is customary for the lender to charge an interest rate to cover two things. One is inflation -- the lender should at least expect to get back the same amount of purchasing power as when the loan was initiated. The second is default risk -- the lender should expect to get paid for the risk of letting someone use the money for a while, in case that borrower is not able to pay it all back.
Under normal circumstances, banks are in competition with one another to attract deposits to use for profitable business activities, and this helps keep interest rates up. However, in recent years circumstances have been anything but normal.
The argument against interest
There are several strikes against interest rates at the moment. The business and investment environment is not particularly attractive, so banks are not hugely motivated to attract deposits. In any case, the Federal Reserve has made money available to banks at virtually no cost by driving interest rates down. Inflation has been fairly low, and in the context of deposit accounts, default risk isn't really an issue because of FDIC insurance.
Under those circumstances, you could turn the argument around, and start to wonder why instead of paying interest, banks don't charge you for the safekeeping of your money on deposit. It's a scary thought, but scary pretty much describes the banking environment of the past five years.
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