How do Savings Accounts Work in a Zero Interest World?

The Federal Reserve – the U.S.’s central bank – cut interest rates to nearly zero in early 2020.¹ We’ve seen zero interest rates before – they were effectively zero from the Great Recession of 2008 until the Fed started to raise them in 2015.¹ If you had a bank savings account during that time, you probably remember your money earning very little interest.

If you put your savings into some types of low interest accounts, inflation will reduce the spending power of your money over time (see “Inflation 101: Meaning and Causes”). But there are alternatives that can help protect your savings. This article explains:

• Why interest on standard accounts drops.
• Why banks and other financial institutions offer alternatives with higher interest.
• The three main types of higher-yielding alternatives.

To answer this question, you’ll need to know a little bit about the Fed’s rates and how the banking system works.

The Fed raises or lowers interest rates to keep the U.S. economy running smoothly so that unemployment stays low and inflation doesn’t get out of control.² The interest rate that the Fed directly influences is the federal funds rate, which is the rate at which banks borrow money from each other to make up for funding shortfalls if, for example, a lot of customers withdraw their deposits at once.² But banks borrow these funds for very short periods of time, typically overnight. The financial crisis of 2008 showed us that when banks become too reliant on such short-term funding, they can become unstable. As a result, banks are now required to keep larger amounts of “stable funding” – in other words, money that can’t easily be withdrawn.³

You can withdraw all your money from a standard savings account or interest-bearing checking account without notice. And if you do, the bank might have to borrow overnight from another bank to balance its books. To obtain more stable funding, banks provide a range of products with higher interest rates, but which tie up your money in various ways, such as high yield savings accounts and certificates of deposit (CDs). To encourage you to move your savings into these products, banks pay much lower interest on standard savings accounts. Typically, they pay about the same as they would have to pay another bank for overnight funds – which, in a zero-interest-rate world, would be pretty much zero.

So one way of increasing the return on your savings is to move them into higher-yielding bank products, if you can afford to tie up the money for a while. There are three basic types:

• High yield savings accounts.
• Money market accounts.
• Certificates of deposit.

Money market accounts are a special type of savings account intended for large amounts of money. They typically offer interest rates above those on high yield savings accounts, but lower than CD rates.⁷ There is usually a minimum balance requirement.⁸ The interest rate can also fall sharply if the balance drops below the minimum.⁹ As with high yield accounts, the interest rate can change, so if the Fed cuts rates, the interest rate on your money market account could fall.

Money market accounts offer similar facilities to high yield accounts. Money can be deposited or withdrawn at any time using online transfer or via ATMs, and some accounts have checks or debit cards.⁸ As with high yield accounts, the number of withdrawals per month for some transaction types may be limited.^8,10 There may also be maintenance charges.

Despite their name, money market accounts are banking products, and therefore benefit from full FDIC insurance up to a limit of $250,000.⁸ In this respect they differ from Money Market Mutual Funds (MMMFs), which don’t have FDIC insurance.⁹ As MMMFs are also sold by banks as investment products, it’s important to check the terms and conditions carefully to ensure you are buying an FDIC-insured money market account.