You are here: Home » Banking » How Do Banks Make Money by Offering High Interest Rates?

How Do Banks Make Money by Offering High Interest Rates?

by Ryan Guina

Have you ever wondered how banks can offer higher than average interest rates on savings or checking accounts? Banks are in the business of making money, even if that means taking a loss sometimes. While that might sound counter-intuitive, it often works out well in the long run.

Take a look SmartyPig and PerkStreet Financial, two relatively new financial institutions bringing in droves of customers, and for good reason – SmartyPig offers higher interest rates than virtually any other bank, and PerkStreet offers best in class debit card rewards, starting at 2% cash back.

How do they do it? To answer that we first have to look at how banks make money. Once you understand how banks make money, then we can delve a little deeper and look at how marketing and other factors play a role in their product offerings. Then we can see how some of these banks are able to offer interest rates and rewards that far outpace their competition.

How Can Banks Pay Higher Interest Than Other Banks?

Now we’re getting into one of my favorite topics – marketing. Since the Federal Reserve sets interest rates, you would think most banks would be fairly competitive when it comes to setting interest rates. And for the most part they are. Check out this list of the highest interest rates and you will see most are reasonably competitive.

But if you look closely, you will see SmartyPig offering over 2% interest, over half a percentage point higher than the next bank, EverBank, and over 1% higher than the lowest ranked banks. What gives?

Marketing, Customer Acquisition, and Loss Leaders

Acquiring new customers is an expensive proposition for just about every company in the financial industry. This includes banks, online brokerages, credit cards companies, and even financial planners. Many banks and related companies are willing to take a loss on some products in order to bring in new business. These products are often called loss leaders because that particular product or service operates on a loss, but they lead new customers to the company. There are many ways this works. Here are a couple examples:

SmartyPig offers the highest interest rates – how?

How does SmartyPig make money? SmartyPig offers the highest interest rates you will find right now, but how can they offer interest rates that are so much higher than everyone else? There are actually several ways. The first, is like all deposit accounts, the bank can re-lend the money they have on deposit and make interest on the loans they issue from those deposits. That isn’t quite enough to offer the highest interest rates in the nation, so they subsidize it with other methods, such as partnering with a host bank, in this case BBVA Compass, which benefits from having the deposits to make additional loans, as well as cross-promotional opportunities. SmartPig also makes money by limiting deposits (limiting the amount of interest they pay) and partnering with large businesses to offer discounted gift cards and making a finders fee on the sale.

Limits on SmartyPig deposits. The highest interest rate at SmartyPig only applies to balances of less than $50,000. If you deposit more than $50,000, your entire account defaults to around .5% interest, which is less than many other leading banks. The high interest rate is enough to attract many customers, and limiting the amount people can deposit at the highest interest rate limits any potential losses. This is still a great opportunity for consumers, however, so long as you don’t have over $50,000 to deposit, or if you don’t mind splitting your funds between more than one institution (of course you can also open two accounts if you are married, effectively getting the higher interest rates on up to $100,000 – not a small sum by any means).

Gift card arbitrage. Another method SmartyPig generates profits is giving customers a chance to redeem their savings for discounted gift cards (When you open a SmartyPig account, you are required to set a savings goal). For example, if your savings goal is to save $10,000 to renovate your kitchen, SmartyPig will offer you a big discount on a Home Depot or Lowe’s gift card. Some discounts are up to 12% for the consumer, and SmartyPig also offers a match on some gift card purchases, making your money go further. (Imagine buying a $10,000 gift card for $9,000; of course you’ll take it if you were planning on spending the money anyway!). SmartyPig buys these gift cards at a discount, so everyone wins. The store gets your business, you get a huge discount on your gift card, and SmartyPig makes some money by referring your business to the store. It’s effective marketing at its best.

Interested in SmartyPig? Click here to visit our SmartyPig review for more information.

What about high interest checking? How can it pay 4% interest?

High interest checking accounts are a relatively new business model that is sweeping the nation, with some banks offering high interest checking paying upwards or 3-5% interest. That sounds like an incredible deal, considering the highest savings account interest rates are typically in the 1.5% range, or just over 2% for SmartyPig. How do they do it?

Again, this is a loss leader for the bank, aimed at bringing in new customers with the intention of receiving more money in deposits and potentially making new loans or generating other business. However, that doesn’t mean they are always a good deal. Many of these high interest checking accounts have minimum and maximum deposit requirements and dropping below the minimum requirement drops your interest rate to almost nothing, and anything above the max deposit limit also earns a low interest rate. Often the max deposit is only around $20,000, so it is enough to get customers in the door, but they are limiting how much they are willing to spend once they get you. Many of these accounts also generate income via fees. Here are my thoughts on the pros and cons of high interest checking accounts.

Other examples of high interest rates, rewards, and other benefits

Here is a short list of other accounts and products that offer consumers generous rewards or interest rates:

  • PerkStreet Financial rewards debit card. PerkStreet Financial offers a 2% cash back debit card (and up to 5% for purchases in certain categories), which is unheard of in the marketplace. How can they afford to do it? Well, they don’t pay interest on deposits, and they offer consumers the ability to redeem rewards for gift cards and other benefits. Of course you can also receive your rewards as cash, making this a great program for consumers. You can’t match a 2% rewards debit card anywhere! Learn more about PerkStreet Financial.
  • Sallie Mae Upromise 10% match. Sallie Mae Bank offers consumers a 10% match on all Upromise earnings if you link your Sallie Mae and Upromise accounts.
  • Sign up bonuses. Capital One 360 is famous for its $25 referral program, where new customers can receive a $25 bonus for opening a new account and the referring party receives $10. Using word of mouth and spending $35 to acquire a new customer is a great business model for Capital One 360.
  • Credit card rewards programs. Many credit card companies offer sign up bonuses, cash back, and other offers as a way to bring in new customers. Again, the cost of landing a new customer makes these offers worth it in the long run. See Chase Freedom® Visa – $100 Cash Bonus as an example.

Another way to offer higher interest rates and better rewards – Limiting costs

Many of these companies are also able to offer better interest rates or rewards programs by limiting costs. Many of these companies are online only and do not have to maintain hundreds or thousands of brick and mortar buildings. Office space, grounds maintenance, and utilities can cost millions each year. Many of these companies also limit costs by only providing electronic statements, which limits their paperwork, processing, and postage costs, allowing them to pass on the savings to the customers.

Are these accounts worth signing up for?

Absolutely – as long as it is an account you plan on using. Right now banks are like many other businesses in this rough economy – they are struggling to maintain and grow their customer base. To grow, banks need to get creative. Some of these offers are great, SmartyPig and PerkStreet Financial, for example. And some of these offers can be less than exciting once your read the fine print, many high interest checking accounts come to mind.

My recommendation: Read the fine print and determine if the benefits outweigh any fees or restrictions. If you find a product or service that meets your needs and there is an additional offer that makes it better, then go for it!


Published or updated May 21, 2013.
Print or e-mail this article:
Print Friendly

{ 6 comments… read them below or add one }

1 Hank

It is kind of backwards that SmartyPig would give its smaller customers the best rates. Many banks do it in the exact opposite fashion. They give their best rates for those depositing the most money. Like short selling, it seems that they are capping their upside potential doing that.

Reply

2 Ryan

Hank, in this case, SmartyPig limits the max deposit so they don’t lose money. They are offering considerably higher interest rates than the next closest bank, which means the difference essentially comes from their profits. SmartyPig needs to put a limit on max deposits to be able to afford to pay the difference out of pocket.

For their business model, sheer numbers of customers works better than total deposits. Banks paying high interest rates, but not using interest rates as a loss leader, prefer going after total deposits.

The cool thin is that both business models work, and both business models are good for consumers. This gives people options to find the best bank for their needs.

Reply

3 sun

I noticed both SmartyPig lowered their interest rate. You can market a loss leader then decide if you lower the interest rate, how many people will defect? If the interest rate is still higher than your competition, many would stay I imagine.

Loss leaders are a real gamble. I think they don’t translate very well in the Internet world since you don’t have a captive audience. Loss leaders make sense in brick & mortar, but online is so risky. Charles Schwab Stopped their 2% percent cash back credit card because of savvy users that paid off their balance in full every month and did not sign up for other Schwab products: http://bucks.blogs.nytimes.com/2010/04/16/charles-schwab-stops-offering-2-percent-credit-cards/

Reply

4 Ryan

That’s a great point, Sun. There are thousands of people who make a game out of finding the best rates, cash back rewards, sign up bonuses, savings, deals, etc. Many people are able to realize hundreds, or even thousands of dollars in savings , bonuses, and cash back each year. It’s a gamble on both sides of the game as it can backfire for companies offering the savings, and it can backfire on consumers if they miss some of the terms.

SmartyPig lowered their rates, but they still offer substantially higher rates than most other banks. But it’s only good for savings up to $50,000 per account, which limits the appeal for some consumers.

Reply

5 Jorge

Seems like your research left out banks that offer quite a bit more than SmartyPig. My bank, First Bank & Trust, offers 4.01% on balances up to 25k, with no fees or tricks. All they require is direct deposit or bill payment, e-statements, and at least 10 debit card transactions per month. I have been with them for a couple of years, and have enjoyed a very nice rate of return plus excellent service.

Reply

6 Ryan

Thanks for the information, Jorge. It sounds like First Bank & Trust offers a great rate on the first $25k. I didn’t include them in this article because they are a regional bank, and it is much too difficult to keep track of the offers at each regional bank, because there are so many of them and the offers frequently change.

Reply

Leave a Comment

Previous post:

Next post:

.