How banks decide interest on savings accounts
On July 31, State Bank of India (SBI) cut the interest rate for its savings account holders from 4% to 3.5% per annum for deposits up to ₹1 crore. This move gains significance as SBI is the largest lender in the country and other banks could soon start following its example. For deposits above ₹1 crore in savings accounts, SBI continues to offer 4% interest.
A few days later, the Reserve Bank of India (RBI) cut the repo rate by 25 basis points (bps), from 6.25% to 6%. The repo rate is the rate at which RBI lends money to commercial banks. One basis point is one-hundredth of a percentage point. This rate cut is another indication that other banks too may cut deposit rates on savings and fixed deposits in days to come.
While interest rates are going down, it is important to recall that this is not the first time that rates have come to this level. Till 2010-11, for the five largest 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 rates. Since 2011-12, most of the large commercial banks have offered 4% interest. Relatively newer banks such as Yes Bank and Kotak Mahindra Bank 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 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 the 1.54% inflation in June. This would, of course, go down further when we factor in taxes.
RETURNS FROM 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 ₹1 lakh in your savings account today, at 3.5% you would get about ₹9.6 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.
Even if we do not factor in taxes, as soon as the rate of retail inflation reaches 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: bit.ly/2u9Exg4.