Why do banks pay interest on my savings?
Ever wonder why a bank pays you interest on the money deposited in your savings account? After all, you didn’t do anything for it. How can a bank afford to pay interest?
Banks use the money deposited on savings accounts to lend to borrowers, who pay interest on their loans. After paying for various costs, the banks pay money on savings deposits to attract new savers and keep the ones they have. The difference between the money earned as interest on loans, any operating expenses, and the money paid as interest to savings accounts is profit to the banks.
Assume you deposit 1,000€ into a savings account that pays 1% interest. Your interest payment for the year is 10€. The banks now loan your 1,000€ to a business at a 8% interest rate and will earn 80€ in interest income. The difference of 70€ is for the bank. Assuming the bank has 30€ worth of expenses to pay for employees, property, insurance and other expenses, the banks profit from your money is 40€.
Who decides the interest rate?
The interest rates banks charge is mainly based on 3 factors:
- the interest they’ve been able to charge borrowers
- the prime interest rate in the country in which the bank is based
- how aggressive the bank would like to pursue new account holders. Banks compete with each other to attract new savers. You may find a bank that is aggressive in its pursuit of new customers and is willing to pay a higher-than-average rate, and this reducing their margin.
How safe are banks?
Now you wonder what happens if the borrower does not pay back the money. Banks diversify their risk by lending to many borrowers. They know that there will always be some borrowers who don’t pay back in a timely manner. However, the bank will try to reduce this risk by carefully analysing each loan application. And if at the end the borrower does not pay back, the bank will pay for it by compensating with the income from other loans, reducing their profit margin. Additionally, most countries have regulations to protect savers from a bank going out of business. In Europe, up to 100.000€ is protected per person and per bank.