Traditional brick and mortar banks are convenient for your checking account and small dollar savings accounts, but you should avoid keeping any substantial savings with traditional banks if you want to maximize the potential for your hard earned money! Online banks offer much higher rates of interest and can be easily linked to your traditional bank, allowing you to move money bank and forth in a few days right from your computer.
For purposes of this discussion, we are not talking about investing the money (stocks, bonds, etc.) but rather finding a risk-free place to park your general savings for the highest return possible. This might be money you are keeping as an emergency fund or savings for a planned purpose for use in a short time frame (a few months to a few years) that you don’t want to be subject to the volatility risk of the stock or bond markets.
At the time of this article, online banks are paying 2.25% or better for a savings account. You can check out the best rates at bankrate.com. That dwarfs the traditional banks that are paying a measly 0.15% or similar. That is a significant difference!
Banks make money primarily on the interest rate spread of their portfolio. That is generally the difference between the interest income they earn on the loans they give out minus the interest expense they pay on savings accounts. Traditional banks are at a disadvantage because their interest rate spreads are only about 3% which is roughly 4% interest income on average loan rates (mortgage loans, personal loans, car
loans) minus 1% interest expense on deposits and CDs. Online banks, however, often have a much larger interest rate spread. Discover Financial Services, for example, has a net interest rate spread of about 8% (10% income on loans less 2% expense on deposits). The advantage of some of these online organizations, such as Discover, is that they earn much more than traditional banks due to higher interest income earnings from credit cards (13%) and student loans (8%). Because of the higher interest income rates, these online banks can easily afford to offer you 2% or better for your deposits and still make a very good profit. In other words, they are paying you 2% on your savings and then they are taking that money and loaning it out at an average of about 10%. Traditional banks can’t do that due to their much tighter interest rate spread. In addition, online organizations are not saddled with the additional fixed costs of having lots of physical brick and mortar branch locations. But, let’s not feel sorry for traditional banks, because even at a 3% net interest rate spread they are still making a good profit.
Investing in an online bank is painless, and once you are set up you can easily link it to your traditional bank which allows you to move money back and forth between your banks with ease. I recommend keeping your traditional bank accounts for convenience, but just keep the minimum amounts required to avoid fees. Any excess funds would do much better in the online bank.
As I mentioned earlier, bankrate.com is a good place to start to review your options of online banks. You’ll want to select the savings icon to view the rate choices. Before moving forward with one of the featured banks, click on the offer details and make sure you can meet the requirements. In many cases there is no minimum balance required, but in other cases there is. Make sure you can meet those requirements to avoid fees. Signing up and linking to your traditional savings or checking account is easy. Once you transfer funds you are good to go!