Why Savings Account Interest Rates Are So Low

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In 2006, I started writing about personal finance. One of the first topics I wrote about was the online high-yield savings account. (See also: The Best 5 Online Savings Accounts)

Back then, these accounts were all the rage. I opened an account offering 5% APY and wrote about how great online accounts were for emergency fund purposes. A deposit of $1,000 meant a little more than $4 in interest the first month.

Now, you'd be hard-pressed to find a high-yield account offering much more than 1% APY, providing you with right around 83 cents in interest the first month. That's a big difference.

But why are interest rates so low on savings accounts? Shouldn't we want to encourage savers in our current economy?

Depositors vs. Borrowers

In reality, banks can pay whatever yield they want on a savings account. If a bank wanted to start paying 5%, it could. There's nothing stopping it, except the desire to turn a profit.

Banks set yields on deposits based on the rate they can get for lending money. The difference between what a bank receives on mortgages and auto loans and other credit, and what the bank pays out in yields to depositors, represents one of the bank's revenue streams.

In 2007, when I bought my home, the best interest rate available to me was 6.02%. By then, the yield on my savings account had dropped to 4%. Now, you can get a mortgage for right around 3.50%. As long as a bank is able to lend at a rate higher than what it pays to depositors, there's a better chance of profit.

So why even pay depositors at all? The reason is that banks are required to keep some capital in their reserves. They are required to keep money in — for lack of a better word — the vault in order to lend. For the most part, credits and debits appear on paper and digitally. But those records have to show that the bank has money in reserve.

Hence the need for depositors.

Banks need to attract depositors to put money in the bank, so they have something to lend (or something to leverage). A bank pays a yield in order to encourage you to park your money in an account; the bank then lends the money at a higher rate than it pays you.

The Federal Reserve and Savings Account Rates

So why are mortgage (and other loan) rates so low? What sets those rates?

The Federal Reserve plays a large role in determining what the rates look like. There are two main rates that come into play:

• Federal Discount Rate: This is the rate at which the Federal Reserve lends money to the banks.
• Federal Funds Rate: This is the rate we're all familiar with when the news talks about the Fed "setting rates." This is the rate at which banks can lend money to each other.

The Federal Reserve prefers banks to lend to each other, rather than borrow from the Fed, so the Federal Funds Rate is often a little lower than the Discount Rate.

Since consumer spending drives about 70% of economic activity in our country, the ability of banks to lend to each other, and to consumers, to keep the money going 'round the economy is a big part of what the Federal Reserve does.

Lower Fed Rates Encourage Borrowing

In times of economic turmoil and difficulty, the Fed lowers the two rates in order to encourage borrowing. Right now, the Fed Discount Rate is at 0.75%, and the Fed Funds Rate is operating in a target range of between 0% and 0.25%.

In a down economy, with so much of the activity dependent on consumer spending, the goal is to attract consumers to loans. These low Fed rates bring loan rates down. Since banks can borrow from the Fed, and from each other, at such low rates, it means they can lend to consumers at lower rates, encouraging them to borrow.

Fed Purchases of Treasuries Reduce Mortgage Rates

Another twist is the fact that the Federal Reserve is still buying long-term Treasury securities. The rates on long-term Treasury securities often influence mortgage rates. As long as the Fed maintains its monthly bond purchase program, long-term Treasury rates are expected to remain somewhat low, keeping mortgage rates down with them.

Of course, once the banks are no longer enjoying higher rates of return on the money they lend, it means they no longer pay their depositors a truly high yield.

When Will Savings Account Rates Go Up?

Following the last policy meeting for the Federal Open Market Committee (FOMC), the body that sets interest rate policy, Federal Reserve Chair Ben Bernanke announced that interest rates will remain ultra-low until 2015. The bond purchases will continue for now, but they are likely to be reduced as a prelude to an interest rate hike from the Fed.

No one knows for sure when the Fed will decide to hike rates. The FOMC makes its decisions based on how members feel the economy is faring. If the economy is heating up, the Fed raises interest rates in order to slow inflation and keep growth in check.

As the economy improves, interest rates are more likely to rise. There isn't the need to encourage banks and consumers to borrow, so rates are allowed to rise. Once the interest rates on loans begin rising, the yields on savings accounts are likely to begin rising as well.

Until then, consumers are stuck looking for yield in places other than savings accounts. Many are turning to the stock market, since all of these efforts at economic stimulus are aimed at helping businesses borrow at lower rates (and boost their profits). However, there are larger risks with stocks than with cash held in a bank insured by the FDIC.

If you have debt, though, now is a good time to aggressively tackle it. With interest rates lower, more of your payment goes to principal. And paying off high-interest debt will offer you a better return on your money than watching it languish in a savings account.