Interest rates are so low now that it makes sense to pay off even low-interest debt. But interest rates will rise again.
When I first started The Simple Dollar in late 2006, it was pretty easy to find a savings account that offered a 4% annual return on your deposits. Some banks, such as HSBC Direct, were offering introductory rates as high as 6% annually.
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Trent Hamm The Simple Dollar is a blog for those of us who need both cents and sense: people fighting debt and bad spending habits while building a financially secure future and still affording a latte or two. Our busy lives are crazy enough without having to compare five hundred mutual funds ? we just want simple ways to manage our finances and save a little money.
In other words, if you deposited $1,000 into an account at HSBC Direct at that time, it paid you $5 a month.
Rates like these were competitive with the long term returns one might expect from the stock market. It actually made good sense from a long-term investment standpoint to have at least some of your money in savings. Savings accounts are incredibly liquid, virtually risk free, and they were getting 4-6% annual returns? That?s a pretty good investment choice right there.
Today, you?re extremely hard-pressed to find a savings account that offers better than 1.5%. Some banks offer higher interest rates, but they?re tied to specific savings requirements, minimum balances, usage requirements, and other factors.
What happened? Why did savings accounts go from having very nice returns to having tiny returns?And will those higher rates ever return?
How Banks Set Savings Account Rates
To understand this story, you have to understand why banks offer savings accounts to begin with and how they decide what rates to offer.
For the most part, a bank can offer whatever rate they want on a savings account. If one bank decided to suddenly start offering a 5% return on savings accounts, they certainly could do so.
The only problem is that it would be a really bad business idea. Banks want some deposits in their savings accounts, but unless they can lend out money at a higher rate than they are offering on savings accounts, they?re not going to make money. They?re going to lose money.
For example, let?s take a look at home mortgages. Right now, you can pretty easily get a home mortgage at 4 to 5% interest. In order to lend you that money, banks have to have that money (technically, they have to have a portion of that money because they can count the mortage payments they?re going to receive? but that?s a whole different issue) in their vaults. In order to have that money, they have to have people depositing their money into that bank, and in order to get that, they have to offer some return on that deposit. At the same time, they have to offer less of a return on that deposit than they?re able to make from mortgages. So, the rate they offer has to be somewhere above 0%, but somewhere well below the 3-4% they get on mortgages.
Thus, we have interest rates on savings accounts hovering around 1%.
Five years ago, we lived in a different situation. Fixed rate home mortgages were much higher then ? 7 to 8% interest rates were typical. At the same time, banks were making a lot of home loans. Remember that housing bubble of the late 2000s? Yeah, that?s what we?re talking about.
In order to be able to make those loans, banks legally needed at least some of that money in their vaults, so they cranked up the returns they offered on savings accounts to get some money into their vaults. Thus, you often saw interest rates on savings accounts inching up into the 4% range.
The Federal Reserve?s Role
Now, these rates aren?t set entirely by magic. Our old friend the Federal Reserve plays a role in all of this. The Federal Reserve bank has the ability to loan money to banks at a certain rate, known as the Federal Discount Rate. They also control another rate, called the Federal Funds Rate, which is the rate at which banks can lend money to each other. The Federal Funds Rate is usually a little lower than the Federal Discount Rate because, ideally, banks will loan money to each other. When you hear about the Federal Reserve ?printing money,? it basically means that they?re making new money available to banks because they won?t (or can?t) lend to each other.
The way the economy usually works is that when the economy slows down, the Federal Reserve lowers these two interest rates so that it?s very easy for banks to lend money to each other and borrow from the government and thus easy for banks to offer low interest loans to businesses that want to get started. This causes the economy to pick back up.
At the same time, when the economy is roaring along, the Federal Reserve usually raises those rates over time to control inflation. If they kept the rates constantly low, banks would continually request new money from the Federal Reserve, and adding new money to the economy means that every existing dollar is worth a little less. In other words, it?s the dreaded inflation.
So, right now, the economy is weak. The Federal Reserve has the rates about as low as they can go so that, once companies start spending and borrowing again, it?s as easy as possible for the banks to lend them money at a very inexpensive rate.
It?s because of these low Federal Reserve rates that mortgages are so low right now. Banks can get money from the Federal Reserve to cover mortgages at 0.75% and they essentially sell them at around 4%, keeping the difference as their profit.
It makes no sense, when they can get money from the Fed at 0.75%, to offer much more than that on a savings account. They?d be absolutely silly to offer anything close to what the mortgage rates are, too. The only reason they might offer a little bit more than they could get from the Federal Reserve is because they?re required to keep some money in their vaults if they want to lend out money.
As a result, you?re seeing interest rates on savings accounts at around 1% or so.
Will This Ever Change?
Unless you?re an extreme economic pessimist, the answer is yes. We will eventually see the Federal Reserve raise their rates again as the economy gets rolling again.
When that happens, mortgage rates will go up. You?ll also see some people tempted to take their money out of savings accounts because the economy is doing well again. They?ll want to buy stuff (because consumer confidence is high) or invest it in stocks (because the stock market will have been doing very well at that point).
To keep the money in their vaults, banks will want to raise interest rates. They won?t raise them as high as mortgage rates, but they?ll compete a bit with each other because the more they have in their vaults, the more they can lend, and the banks want to lend. It?s how they make money.
What Should I Do With My Savings Account Money?
If you have money in a savings account and are reading this article, you?re probably disappointed in the 1% (or so) return you?re getting lately. Surely you can do better than that?
Your best option is probably to simply pay off debts if you have any. Almost all of your debts should have an interest rate much higher than 1%, which means you?ll get a much better return on your dollar by making an early debt payment. The only catch is that you won?t actually see that dollar again until the loan is paid off. Paying off debt essentially locks up your dollars and you don?t see the returns until your debt disappears early.
Other options that allow you to still be able to access your money have other problems. If they?re stable investments, they?re usually pegged in some way to those Federal Reserve rates above, meaning you?re not going to get a great return. If they?re risky investments ? well, you?re taking on a risk that you?re going to lose some of your balance.
In my eyes, paying off debt is the best choice as long as you keep a healthy emergency fund in a stable, easy-to-access savings account. If you don?t have any debt, start exploring other investments at your own discretion, but still keep an emergency fund.
Good luck!
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