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How is 5% Checking Possible? The Math Behind Reward Checking Accounts

I received some stats from a credit union that offers a reward checking account that currently pays 5.01% APY on balances up to $25,000. These stats show how banks and credit unions can afford to pay the high yield on these accounts. For those not familiar with reward checking accounts, refer to my reward checking overview.

According to the credit union, the average reward checking account holder has an average balance of $7,700 and makes debit card purchases totaling about $900 a month.

Banks and credit unions earn fees for each debit card purchase you make. This is called interchange fees, and a fee of 1.75% appears to be a good assumption (I wasn't able to get this number from the credit union).

Assuming the credit union receives 1.75% from each debit card purchase, the average monthly revenue per account holder would be $15.75 (1.75% of $900).

An average account holder with a $7,700 balance in the 5% checking account would receive about $31 in interest per month. The debit card purchases should offset the cost of this to the bank by about $15.75. So the cost to the credit union after the debit card fees is $15.25. This is equivalent to an interest rate of 2.40%.

Comparisons to Internet Checking Accounts

So thanks to the debit card usage requirements and to the average account holder, the account only costs the credit union 2.40% in interest rather than 5%. Unfortunately, in this current rate environment, 2.40% is a little high for a checking account. Electronic statements help reduce the cost a little bit for the banks, but that doesn't give them an advantage over online banks. Some current rates from non-reward online checking accounts include:
If the credit union finds that it can only afford 1% interest, the reward checking account rate may fall to the mid-3% range.

How Customers Influence Reward Checking Accounts

If account holders maintain larger balances and make smaller debit card purchases, banks will have to pay lower rates. So it's important for banks to attract the Average Joes and not just rate chasers looking for online savings account alternatives. This is one good reason for banks to also provide ATM fee refunds when requirements are met. This feature may be more attractive to the Average Joe than the high interest rate.

You can tell the Average Joes are not typical readers of this blog. In my survey at my reward checking website, 56% reported making under $100 of monthly debit card purchases, and 79% reported making under $500 of monthly debit card purchases.

If you're looking for a reward checking account for the high interest rate, you may be better off with one that isn't nationally available. I would think banks that only allow locals to join would more likely have a higher percentage of Average Joes.

Restricting Accounts to Local Residents

It appears banks and credit unions have noticed this issue and have made changes to their accounts. One example is MidWest America Credit Union which had been offering 7% APY for balances up to $25K. For a while anyone could join via an association membership. However, the credit union changed their eligibility requirements. Members of that association must now also live within 100 miles of one of the credit union branches to be eligible to join (see post). Similar changes have occurred at Golden Plains Credit Union in Kansas (see post), Southern Missouri Bank (see post) and Citizens Bank Minnesota (see post).

Forcing Larger Debit Card Purchases

In addition to restricting accounts to local residents, banks have done something more drastic (and disturbing). Some have closed accounts of customers who met the debit card requirements with too many small purchases. This happened at both Citizens Bank Minnesota and Southern Missouri Bank. Here's what Southern Missouri Bank now states in its small print:
This account is intended to function as a primary checking account. MasterCard check card transactions should be for ordinary and customary expenditures, not simply 12 de minimis transactions designed to qualify for rewards requirements.

The problem with this is how do you define de minimis transactions?

Cutting Rates

The other alternative for banks that have too many account holders with large balances and small debit card purchases is to just lower the interest rate. It appears this is what may have happened at West Texas National Bank (see post). In late 2007 it was offering its reward checking account nationwide with an APY of 6.01% on balances up to $25,000. The rate fell to 5.01% in April, to 4.01% APY in November and to 2.01% this month. You can still get higher rates at many online savings accounts with no debit card hassles (even at ING Direct), so there's no longer a reason to have this account if you just care about high interest rates.

Past and Future Reward Checking Account Rates

I now have 312 financial institutions offering reward checking accounts listed in my High Yield Checking Website. The average top APY is now 4.45%. I have 36 institutions in my table of nationally available reward checking accounts with an average APY of 4.46%.

On August 2008, my full list had 245 institutions with an average APY of 5.00%, and my nationwide list had 29 institutions with an average APY of 5.15%.

So you can see rates are falling, but 4.45% is still much higher than any online savings account rate. Most online savings accounts now have rates under 3%. There are still two with an APY of around 4%. The highest reward checking rate is 6.31% APY at MidWest Credit Union, and there are still several with 6% APY.

Last year when I mentioned these reward checking accounts to my local credit union, a credit union manager said they felt that these accounts would be short lived gimmicks to attract new members. After reporting on these accounts for more than two years, it's clear these are not just short lived gimmicks. However, it's not clear if these can maintain rates higher than online savings account rates over the long-term. If they can at least maintain rates 1% higher, I'll keep using them.

New Reward Checking Account Survey

How much do you keep in your reward checking accounts? Is your balance like the average of that credit union with a balance of $7,700? Or do you keep a balance near the maximum amount that can earn the top rate? Since reward checking accounts have different balance caps, the survey is only for those with reward checking accounts that have a $25,000 max (the most common cap).

This survey and the previous survey on monthly debit card purchases are on the left side of my High Yield Checking Website.
Marc Schoenfeld
  |     |   Comment #1
Great analysis. It makes me feel that it might be good to make more than just tiny purchases for meeting my requirement so that they don't get all de minimus on me. One stat I'd love to know if you can find out is what the success rate of qualification is for most people to earn the high rate. The high debit card average tells me most people don't have a problem with making that, though. That $900 a month stat is incredible, but maybe a lot of people don't trust themselves with credit cards, even if they can pay off the balance each month. It does seem that it makes no sense for them to make these accounts nationally available unless they are in desperate need for deposits since the non-locals are so much more likely to be skewed as the unprofitable customers. Also, the high cap (50k at West Bank, for instance) also attracts a skewed customer base (I would think) that is more likely to be unprofitable. But like many things, the smart people are subsidized by the fools. That is why there are 0%, no fee, balance transfer offers, free checking, etc. These things that savvy financial people put to good use would not exist were it not for the less savvy people (that OD frequently, keep high balances in non-interest checking, miss payments or don't pay off before the intro rate expires) that misuse them and create profits for the financial companies that engineer them.
  |     |   Comment #2
I keep my balances near the max limit, but unlike the 10 x $1.00 crowd I try to spread my purchases out among a variety of stores (grocery, pet store, department store) to make it appear that it's like a regular checking account.

I guess the $1.00 crowd skims off the interest to avoid going over the max; I leave the interest in to balance my spending.
  |     |   Comment #3
I'd question the 1.75% debit rate - that's higher than the rates quoted to merchants for debit card processing fees, before the processor, Visa, etc skim off their cuts. I'd guess the profits are just as much derrived from float on transactions (deduct from your account today, dont send out the money until tommorrow).

I'd also like to see the monthly qualification rate for these accounts; I'd bet they pay the high rate on far less than the average balance of $7,700. A $7,700 avg balance also means that for each person with the maximum balance, there are 2 accounts with a balance of zero - leaving a decent opportunity for misc fees like overdrafts/bounced checks.

And your cost analysis doesnt account for the ATM rebates that are a common feature on these accounts. That's pure expense.
  |     |   Comment #4
I have an account I keep $23,000 in and another with $20,000. I need 10 transactions for each account. Most of those I get from fast food lunches at an average of $4. I have a few larger charges maybe 3 or 4 at $30. I never use the ATM. Big purchases I put on my cash back credit card.

The bank can make additional money in the months that you don't meet the requirements. I have missed twice. Also they make money if you go over the $25,000.
  |     |   Comment #5
Very informative posting, Banking Guy.

I was heavily into Reward Checking when there was a bank offering a very high (or even unlimited) ceiling and a high rate.

Now that most Reward Checking accounts have a low ceiling, I pulled out, as I suspect many others did as well.
  |     |   Comment #6
I guess that I am not among the average Joes who open these type of accounts. I was aware of the "commission" involved with debit card transactions so I knew the requirement for the minimum number per month was to provide some money back to the bank. I make a lot of small purchases at grocery stores, gas stations, and drug stores. My big monthly payments go to the credit card bills which can't be paid by debit cards. I might be able to make the minimum purchase requirements of these type of accounts, but the balance ceiling for the high rate doesn't make it worthwhile.
  |     |   Comment #7
I keep the maximum in my rewards checking account.
I would also think that rewards checking accounts would make money from things like overdraft checking. Most of these avg joes would have to make 10-12 transactions/month.. Some of them are destined to spend more than they have in their checking..
  |     |   Comment #8
The minimum transaction thing is interesting. I have not made a debit transaction from any checking account I have in ages. If I opened a reward checking account I would have to change my regular habit just to make those transactions and by default it would be way more money in debit transactions than usual for my "primary checking account" and thus shouldn't be a reason to close.
  |     |   Comment #9
You are all partly right, partially wrong, including the banking guy.

First, it's not whet you know, but what you don't know that counts.

I used to work as background accountant for a bank and I used to do similar accounting and analysis to balance the monthly bookkeeping.

The banks do not operate on our logic or way of thinking. The 10 or 12 monthly debit charges are irrelevant to the bank. Those requirements are to create float, together with the high balance tease in order to make meaningful for the customer to keep high balances.

Visa or master card, do not get paid until 30 days from the day of posting the purchase, but the money are instantly withdrawn form the account. The banks sweep all of deposited balance in a treasury account immediately, hence created balance base against which can borrow or lend money up to 10 times from the treasury balance. This is creating a huge float against which the bank can invest in other securities, similar to derivatives with leverage.
For every dollar seating in your checking account, the bank controls tremendous balance sheet.
These sweeps in and out are done on daily bases and some of the money gets invested overseas in currencies that pay much higher interest than 5%.
There are numerous other tricks that the banks use, like not crediting your deposits immediately, putting holds on the available funds, if you deposit on Friday, you will not get paid interest until Monday, if you withdraw on Friday they do not pay the other bank until next Friday and so on. It may not seems much to you, but thousands of accounts with thousands of dollars in it with thousands of delayed payouts, and when you include the leverage of 10:1 ratio, you get big profits.

I'm not allowed to go into details, but there many others tricks that I purposely left out, due to being sworn never to release them in public forums.
  |     |   Comment #10
My Reward Checking account clearly states that they use the daily-balance method to calculate the interest; hence it applies a daily periodic rate to the balance in the account each day. THey state interest is compounded daily and credited on last business day of statement period (but isnt available until the first day of the next statement period.) So, if I deposit $150 nonlocal check on Friday before 2:00pm cutoff, my bank still considers the entire deposit for Friday's balance (even though the Schedule of Fund Availability states first 100 avail next bus.day(mon), and the rest 2 business days thereafter). True, my deposit gets pumped into treasury account that allows the bank to get more support leverage, and that allows the bank to invest, or lend out and make profits. But, my bank pays me 4.8% APR per month. I used to think the issuing bank of debit cards make some money when I use it as signature-based transaction.

I still dont see how my bank is making alot off of me, or ratechasers and bankdeal's fans. Question: How much does it cost a bank to produce statements, envelopes, send with bulk-rate discounted postage, ink/toner, and stationary? Is this a factor in their cost-savings for operating these rewards accounts.

But, as mentioned ealier, how about the factor of nationwide (us only) ATM surcharges. I've seen ATM surcharge fees of $4 atcasino, per transaction. So, if i take out $20 x 5 times at a casino, I now have $100cash & $20 atm fees deducted...of which get reimbursed at end of month! That's alot and I wonder if that adds costs and hurts these rewards. Plus, with average savings accounts at 2.75; how can these rewards at 5+% still exist?

Still, whether it's possible to have 5% checking where mortgage rates are now also at around 5.25% for 30y,fix; it's still open. These rewards checking surely changed my behavior toward banking and spending. I too rarely used a debit card for purchases; now, i do (but i try to use small quick purchases with debit now, upto the required monthly transactions). But, there is still that risk with debit cards of transaction errors or fraud that can produce mass headache and agony to resolve (with potential NSF/overdrawn fees). Plus, always having to login and print checks i write monthly for receipts has become cumbersome. (Ridiculous: my bank charges $5 item fee for copy of check or deposit items or per statement). Also, there's extra risk involved in resolving billing or disputes with purchases with debit card (or errors). And, as some1 mentioned, if you just use debit card for say pack-o-gum for 79cents, times 15, how does the bank make money! Bonus, I use BoA ATM 20days x$2fee per month!?!
  |     |   Comment #11
The ATM surcharge fees are nothing but fraud on the consumer. Almost every bank now is a member of the ATM nationwide system and cost them only pennies per transaction, but they want you to believe that you are being paid back for essentially that is our money deducted during the transactions.

ATMs are actually point of sale ACH paid to you. There in no actual transaction taking place as the banks wants you to believe.

They wait for our mistakes or ignorance to make a lots of money on all kind of fees.

The average daily balance is also a fraud. If a had one dollar as a balance and deposit $1000, my daily average balance is $500.50.

Every which way you turn a "land mine" is waiting for all kinds of fees. So, going into the depth of this article, I conclude that the banks are working against us and paying higher rates then usual because of created float and exuberant fees.
  |     |   Comment #12
You guys need to understand that a large percentage of people with these rewards accounts **** up and lose at least a month of interest. If you are math impaired you might not realized that this can drop your annual APY by a percent or more. The bank is definitely counting on this which is the *only* reason they are able to offer these rates.

If you consider yourself a rate chaser and have ****ed up even one single month with one of these accounts, you have completely wasted your time. - sfchris
  |     |   Comment #13
"If you consider yourself a rate chaser and have ****ed up even one single month with one of these accounts, you have completely wasted your time." --Mathematically, miss 1 month, it yields 0.1% and normally 4.9 yields 4.5; miss 2 months, you get 4.1; miss 3, 3.7%. Still, that rate is ok today, assuming reward yields stay at 5.0%apy for another year. Of course, any ATM machines that charged you wont be reimbursed the missed months. Re:ATM; the bank owners of ATM have costs to operate, maintain it, lease space (if not at bank location), and pay interchange fee for ATM network. If your bank also charges you for not using one of their ATMS, then that fee offsets their fee that they pay for interchange fee...the rest is profit.
  |     |   Comment #14
How about how fractional reserve banking plays into this? Banks constantly remind us of how little they make by paying us the "high" rate of interest. But how about the dishonest and unethical (although legal) practice of fractional reserve banking that lets them loan out 10X what they have on deposit? My $25,000 deposit thus enables them to loan out, and collect interest on $250,000.
  |     |   Comment #15
No, Stuart, that's not how fractional reserve banking works.

Let's say you deposit $25,000 into Citibank. Then Citibank makes an auto loan to Joe Smith. Joe Smith takes the check from Citibank to the auto dealer. The auto dealer deposits the check into his account at Bank of America. Bank of America presents the check to Citibank. Citibank needs to have $25,000 to hand over to Bank of America. Citibank can't make any more loans until someone else makes a deposit (or they borrow some money from the Fed or another bank).

That's where all the conspiracy videos and web sites get it wrong. If Citibank issues a borrower a check for $25,000, they have to have $25,000 on hand (technically on the books in their clearing account at the Fed) in order to pay off the check. When the check is paid off, that money is gone from Citibank's account and they can't make any more loans. The conspiracy videos tell you that Citibank can somehow pay off the check without debiting its account. It can't.

Now, if by some stroke of luck, the auto dealer also happens to be a customer of Citibank (instead of B of A) and deposits the money back into his account at Citibank, then yes Citibank can make another auto loan. Well, at least until the auto dealer needs to pay his employees and suppliers, at which point he will write them checks which Citibank has to have enough money on hand to honor in case the employees and suppliers deposit their checks at B of A instead of Citibank.

Fractional reserve banking refers to money created by the Fed. The Fed is the only entity that can cash checks (figuratively speaking) without having any money on deposit.

Citibank (or any other bank) can create money in the sense that if they give out a loan and the loan proceeds get redeposited (directly or indirectly) at Citibank, they can lend them out again. So if you make a $25,000 deposit, they make a loan, and the auto dealer redeposits the $25,000 at Citibank, then both you and the auto dealer have deposits at the bank and between the two of you, you now have $50,000 on deposit. But at this point the bank only has $25,000 in its account plus a note from the borrower valued at $25,000. The bank could relend the $25,000, but it has to carefully manage its cash so that if you or the auto dealer want to make a withdrawal, they have enough money on account to pay it off. In the real world, of course, the bank has thousands of depositors and, statistically speaking, they know that only a small fraction of them will make withdrawals on a given day. They can lend out the amount over the statistically expected withdrawals. When depositors don't behave according to statistical norms, that is called a "run on the bank" and the bank doesn't have enough cash in its accounts to pay all of the checks the depositors have written. Then the bank collapses.
  |     |   Comment #16
I am sure that banks use hidden techniques to provide earnings that are not known to the general public. We should all invest in overseas currencies that are paying over 5% and open a FOREX account. I am sure that they play the float game in order to maximize the use of your money before it has to go elsewhere. The one game that I have never accepted is the amortization loan schedule when you take out any kind of loan. Where is it written that the first loan payment has to be 99.99% interest and the very last payment is 99.99% principal? And where is it written that the overall payout for the loan is usually 2 to 3 times the original loan amount? Since interest rates can change daily so that what you borrow on a loan and its overall payback will fluctuate, why doesn't the amortization schedule also fluctuate? I am not a student of economics, but this loan payback system is all ****ed up since it was first invented.
  |     |   Comment #17
first off, nobody forces anyone to take a loan; it is a private transaction so the bank or whomever should be able to dictate the terms. it is not a scam if you agree to it. the bank exists to serve its interests which happen to at times serve the interests of its customers too.

and i have to agree with bank guy's credit union in that it is just a short lived game. just because a lot of banks got into it, doesn't mean it still isn't small potatoes or going to be short lived. with one large firm doing most the work for them, there is little risk for the bank to dip their toe in the water and pull out if they don't like it when they fill like it, and your starting to see that with some of the new terms coming out, banks are walking to the shallow end.

i'd say some other benefits for the banks are:
> fees: not included in the summaries profits are the fees it will make. prior stats have shown their is money to be made here.
> effeciency profits: if they can keep the same employee costs but push through more transactions, they make more money.
> consumer training: schooling consumers in using bank cards for purchases rather than credit cards.
> attracting new customers: who would have to be attracted with other costly promotions or advertising.
> interpersonal games: vice prez exec Joe needs to show he is improving business so has to do something and here is a new scheme to try; 20 years ago he gave out a toaster instead.
> Direct Deposits: sucking in the reliable and steady monthly DD.
> ING 'yo-yo': playing the old ING game of attracting a balance and hope your forget or find it to difficult to move out when the perks go away.
> full cycle customer data: i'm sure the company running this plan sold a bunch of upsides like offering customer profile aggregate data. throw in a bunch of other coporate TLM speak as well.
  |     |   Comment #18
"Citibank (or any other bank) can create money in the sense that if they give out a loan and the loan proceeds get redeposited (directly or indirectly) at Citibank, they can lend them out again. So if you make a $25,000 deposit, they make a loan, and the auto dealer redeposits the $25,000 at Citibank, then both you and the auto dealer have deposits at the bank and between the two of you, you now have $50,000 on deposit. But at this point the bank only has $25,000 in its account plus a note from the borrower valued at $25,000. The bank could relend the $25,000, ..."

Incorrect. The reserve ratio is 10%, so in this example, the $25k deposited will not allow citibank to lend out $25k. They can only lend out a maximum of 90% of that, which is $22.5k. If the $22.5k is redeposited with citibank, they can then lend out $20.25k.

The 10x multiplier arises if there is only 1 bank, and every loan gets redeposited and reloaned out infinitely times. The summation of the above just happens to be 10.

Note that they can choose to keep more than the mandated minimum reserve ratio.
  |     |   Comment #19
One thing I don't understand is how some of the web only banks that don't offer anything but savings products can offer high rates. One that I recently opened is the Redneck Bank 5.25% deal. They seem to only offer 3 products. A reward checking, MM account, and a checking account for folks that can't get a regular account. OK, I can see a profit from the no interest checking, but those people seldom carry much of a balance.

Unless they can channel deposits back to there mother bank (Bank of Witchitas)to be lended out, how can they afford to pay such a high rate? It just doesn't seem like transaction fees and deposits placed in treasuries would be enough.
  |     |   Comment #20
Treasuries (at least the short term type) are near 0%, so you can't make much money with that. You have to invest the money into more riskier investments like subprime mortgages, foreign exchange, and junk bonds to make more for your money. Of course, the traditional ways of gouging the general public with higher loan rates and credit card fees will always provide a big cushion to cover the high interest savings rates. Have you ever seen home, auto loan, and credit card interest rates that equaled the savings rates? The only time that I have seen mortgage rates come very close to savings rates was back in the early 1980's when savings rate hit 10% and lending rates were above 12% and in 2003 when savings rates hit 2% and adjustable mortgages were as low as 3%.
  |     |   Comment #21
I agree that banks earn a lot through withdrwal/deposit timing. When I deposited $70,000 last Friday (hope to earn double interest over weekend), I deliberately confirmed that interest start accrued the same day. But it turns out the deposit does not earn intrest until the next business day. The bank keeps this as their drak secret. I had to go all the way to President to confirm their exact policy. They returned two-day of interest after I complained, but that is one sneaky tool they have.
  |     |   Comment #22
Yes, and when one finds out those dark secrets/ambiguities, the bank may turn against one and closes one's accout. This actually happened to me when I found out that the Friday deposit actually accure interest the following Monday.
  |     |   Comment #23
I am new to Rewards Checking and had a question for anybody that can help me with this. I am somewhat confused about how the debit card transactions work. If these banks want you to have let's say 10 POS transactions a month, is that a "credit" transaction on let's say a 10 gallons of gas? If I'm correct, you don't actually put in your pin # do you to qualify as a transaction? I just want to make sure I qualify for the transactions part of the program. Thanks to anyone that can help me on this.
Banking Guy
  |     |   Comment #24
There are two ways to use a debit card for payment: 1) PIN-based purchase in which you enter your PIN, and 2) credit-based or signature-based in which you don't enter your PIN. For #2, the purchase is handled through the VISA or MasterCard network, and it usually involves more fees for the merchant and more money for the banks. For this reason, #2 is sometimes required to qualify for the reward checking rates.
  |     |   Comment #25
The math in this article is wrong. The first section calculates the monthly debit card purchase fee as $15.75 (assuming fee is 1.75% and debit card purchases are $900). This is incorrect. $15.75 is the annual total, not the monthly total. The correct monthly debit card purchase fee collected by the credit union should be $1.31 (($900*.0175)/12). Hence, the debit card purchases offset the credit union's payment of $31 in interest per month by only $1.31. The total cost to the credit union is $29.69, which is an equivalent interest rate of 4.6%, not 2.4% as the article claims.
Banking Guy
  |     |   Comment #26
The average $900 per month debit card purchases was quoted to me by the credit union VP.
John Winters
  |     |   Comment #27
I call it my free lunch account. Like many, I work 20 to 22 days a month. I generally go out to lunch. Each lunch is about $10 (usually less). So, if I have $25,000 in 2 checking accounts each, both earning 5%, that's $97 per month. That's 20 free lunches a month. Now, if I underspend, which I usually do, that covers the income taxes on the interest. I could save 1.25% in savings, or, get free lunches every month wherever I want. I'll take the free lunches, thanks. And it works out because I need to have 3-6 months of expenses in an easy to access cash account. What is easier to access than a checking account?
  |     |   Comment #29
lake city bank in indiana has 2.51% with a max. of $50k a great program. the offer.51% on over $50k in a savings account.
  |     |   Comment #30
What is the current status on 2013?

Has anyone been kicked out from a rewards checking account for doing all the debit card puchases for less than a dollar?

Is it possible to open more than one rewards checking account with different Credit Unions on the same month or do I need to wait some time between opening accounts on each Credit Union?
  |     |   Comment #31

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