Why Do Some Banks Pay More Interest Than Others?

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If you pay attention to the financial news, you'll see a lot of talk about how the Federal Reserve makes decisions about where to set interest rates. That gives many people the impression that the rates they get from their bank are determined solely by the Fed. Yet while the central bank unquestionably has influence over the course of short-term rates, you also need to understand that banks are free to pay different interest rates, and shopping around can therefore help you get a better rate on products like savings accounts and certificates of deposit. Let's delve a little deeper into the financial industry to find out why some banks pay better interest rates than others.

How competition for money helps set rates

In many ways, financial institutions set interest rates based on supply and demand for money. Banks see deposit accounts as an opportunity to pull in much-needed reserves to comply with regulatory requirements. For banks that already have an established customer base and that spend large amounts on marketing to attract customers based on their services, paying a high interest rate isn't necessary to maintain the deposit base that they've built up. By contrast, some banks don't do as much to appeal to potential depositors with their service offerings, and for them, boosting their interest rates is a good way to stand out from the pack to get the money they need to shore up their financials.

Yet banks don't have an unlimited ability to offer whatever rates they want. In the past, the FDIC -- the government agency that guarantees deposits at U.S. banks -- has sometimes clamped down on banks that resort to paying high interest rates in an effort to attract deposits to shore up their capital reserves. The FDIC has a vested interest in preventing abusive competitive practices, since it's on the hook if a member bank sets rates so high that it can't afford to pay interest to its savers on a sustainable basis.

Keeping it simple for savers

Moreover, banks know that most customers won't be willing to give up their relationship with their existing bank unless they're given a sizable incentive to do so, and that helps allow successful banks to keep their savings rates lower. If it were easy to set up bank accounts at will, then savers could just gravitate to whichever bank offered the highest rate. Yet the hassle of starting a relationship with a new financial institution can easily outweigh the minimal interest savings you might enjoy.

That said, the Internet and mobile revolution has dramatically changed the landscape for financial institutions. Traditional banks have the huge fixed costs of maintaining a physical building that's safe from potential threats, and the expenses that banks incur to do so eat into the margins they have to treat their customers better. Internet-based banks often don't have any physical locations at all, and that saves a huge amount of expense related to maintenance and upkeep of buildings as well as the staff necessary to operate those facilities.

Finally, keep in mind that banks have to cater both to savers and to borrowers. To the extent that a bank offers savers better interest rates, it usually has to generate the money to do so by charging its borrowers a bit more on their loan rates. If high loan rates push bank customers to get loans elsewhere, it can jeopardize the bank's overall business, and that in turn puts downward pressure not just on borrowing rates but also the interest rates that go to savers.

It's annoying when you discover that your bank doesn't pay as high an interest rate on your savings as a competing bank does, but typically, the only option you have in that situation is to take your money and move it somewhere that values it more highly. If you're not willing to do that much work to find a higher interest rate -- and many aren't -- then you're supporting your bank's decision to pay you less than you deserve.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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