Factors banks look at before deciding the interest on savings accounts

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On 31 July, State Bank of India (SBI) cut the interest rate for its savings account from 4% to 3.5% per annum for deposits up to Rs1 crore. This move gains significance as SBI is the largest lender in the country and other banks could soon start following the example set by it. For deposits above Rs1 crore in savings accounts, SBI continues to offer 4%.

A few days later, the Reserve Bank of India (RBI) cut the repo rate by 25 basis points (bps), from 6.25% to 6%. Repo rate is the rate at which the RBI lends money to commercial banks. One basis point is one-hundredth of a percentage point. While this rate cut was widely expected and factored in, it is possible that other banks may cut deposit rates for savings or fixed deposits in the coming days.

While the interest rates are going down, it is important to recall that this is not the first time the rates have come to this level. Till 2010-11, for the largest five banks in India, the interest rate on savings account deposits stood at 3.5%.

In October 2011, RBI deregulated interest rates on savings accounts, which allowed banks to set their own interest rates. As a result, banks are free to offer any rate they deem fit. Since 2011-12, most of the large commercial banks have offered 4% interest. Whereas, relatively newer banks such as Yes Bank Ltd and Kotak Mahindra Bank Ltd have been offering higher interest rates of 6-7%, with the aim of gaining market share. This variety in interest rates can also been seen among the newly launched small finance and payments banks, with their interest rates varying between 4% and 7.25%.

Why is the interest rate reducing?

After the reduction of interest rate, senior SBI executives explained the rationale for the cut. They said that the real interest rate is very high right now, as the rate of inflation is going down. Retail inflation fell to 1.54% in June, pushing the inflation-adjusted yield on 1-year treasury bills to 4.82%. Real interest rate is arrived at after adjusting the regular, or nominal, interest rate for inflation. So the regular interest rate minus the inflation gives the real interest rate.

This also works for depositors and retail consumers, as a 3.5% return on your savings bank account deposit actually means a little less than 2%, when adjusted for 1.54% inflation of June. This would, of course, further go down when we factor in taxes.

Interest rate for savings accounts

While the interest on your savings bank account deposits is paid to you every quarter, the interest is calculated on a daily basis. So, if you have Rs1 lakh in your savings account today, at 3.5% you would get about Rs9.6 as interest for today. This daily calculation of interest started in 2010.

Earlier, the banks used to pay interest on the lowest amount in your account between the 10th and last date of the month. It was an unfair system, as it penalised depositors and favoured the banks. Read more about this here:

While the current system of calculating interest is better than the older one, you should still watch your actual returns after inflation and taxes.

Even if we do not factor in taxes, as soon as rate of retail inflation would reach 3.5%, your real return could reach zero—if your bank gives you an interest rate of 3.5% per annum on savings bank deposits. So, keep track of other investment instruments that can give you higher returns. Read more about it here:

Keeping excessive amounts of money in savings accounts is obviously not a good financial strategy. In fact, financial planners also discourage people from keeping large sums of money in savings bank accounts.

Compared to savings accounts, liquid funds give better returns as the interest rate on them at present is around 6.5%, which is 1-2% higher than savings deposits.