In this interest rate environment in which savers are punished with low deposit rates and spenders are rewarded with low interest-rate loans, at least we have reward checking accounts which allow savers to profit from spenders. If everyone with reward checking accounts maintained a $25K balance and spent only $50 a month with their debit cards, we would be in trouble. Fortunately, the average reward checking customer maintains a smaller balance and spends more, and it's the average customer who drives what rates banks can offer. So thanks to the average Joe's who spend a lot and maintain small savings, banks can afford to offer high yields on the reward checking accounts.
I thought it would be interesting to see how much debit card purchases and low average checking account balances can help pay for the reward checking yields. Interchange fees are what makes the debit cards profitable for the banks. In this post, I'll look into the issue of interchange fees, and review what may change with the new financial reform regulation.
Reward Checking and Interchange Fees
The main features of a typical high-yield reward checking account are:
- Requirement of between 10 to 15 debit card purchases a month
- High rate only applies to balances of around $25K
Reward checking accounts also require e-statements and direct deposit or ACH debits. E-statements are often mentioned by banks as an important feature that allows them to pay high interest. I find it hard to believe e-statements help that much. Internet banks like ING Direct have done this for years. Their rates are higher than brick-and-mortar rates, but they are much lower than most reward checking accounts.
I think banks de-emphasize the revenue they get from interchange fees since they're not an example of improved efficiency like e-statements. Interchange fees are paid by the merchants when we make purchases with a debit or credit card. These fees are indirectly paid by all of us in the form of higher prices.
The profits from interchange fees are at risk due to the recent financial reform legislation that became law. Debit card fees will be regulated by the Federal Reserve to ensure the fees are "reasonable and proportional to the processing costs incurred." The regulation will only apply to institutions with assets of at least $10 billion. This exclusion didn't prevent small banks from opposing this bill since they feared it would indirectly force them to accept smaller fees. There are still many unknowns. The Federal Reserve will have to develop plans to regulate these fees, and then we'll have to see how it trickles down to the small banks and credit unions.
As is it now, interchange fees from debit cards still provide banks a lot of revenue. Here's an example provided at Wikipedia
For one example of how interchange functions, imagine a consumer making a $100 purchase with a credit card. For that $100 item, the retailer would get approximately $98. The remaining $2, known as the merchant discount and fees, gets divided up. About $1.75 would go to the card issuing bank (defined as interchange), $0.18 would go to Visa or MasterCard association (defined as assessments), and the remaining $0.07 would go to the retailer's merchant account provider.
Effect of Debit Cards and Checking Account Balances
In short, the more customers spend with their debit cards and the smaller the average checking account balance, the higher the yield banks can pay. Here's a basic equation that shows how the reward checking account interest rate can be affected by the monthly debit card purchases, the interchange fee percentage and the checking account balance.
Extra rate from debit cards = 100 x P x F x 12 / B
P = Average monthly debit card purchases for all customers
F = Average interchange fee percentage paid by retailers to the banks
B = Average balance maintained by all customers who meet monthly requirements
It's important to note that this is based on the average customer. A few customers may buy very little and maintain a balance right at $25K. Fortunately for us, they are not typical. Most customers have balances well below $25K and spend a lot more money with their debit card. Data that I received from a credit union in 2009 had one example of what can be considered average. In that case it was a balance of $7,700 and total monthly debit card purchases of $900. NetBanker cited data from BancVue in 2008 that showed the average balance is $9,000.
In the table below I plugged in some reasonable checking account balances and monthly total debit card purchases. I assumed banks get 1% from the interchange fee. Unlike interest rate, this is not annualized. It's a percentage of the monthly purchases. A 1% fee may be a little low, but it can make up for other factors that would hurt the checking interest rate like when customers make PIN-based purchases which typically have a much smaller interchange fee.
How Much Debit Card Purchases Help Reward Checking Rates
|Avg Monthly Debit Card Purchases||$5,000 Avg Balance||$10,000 Avg Balance||$20,000 Avg Balance|
If we assume that without the help from debit card purchases, a bank would only be able to pay an interest rate of 0.50% on its checking account. We would then add 0.50% to the rates above to estimate the reward checking rates that banks can pay based on average balances and average monthly debit card purchases. One example from the above table shows that if customers spend on average $1,000 per month and maintain balances of only $5,000, the bank should be able to pay an extra 2.40% on its reward checking account. If the base rate is 0.50%, that would make for a total reward checking rate of 2.90%.
There are many other factors that come into play that will affect how much the bank will be able to pay in interest. It should also be noted that most reward checking accounts refund ATM surcharges. This costs banks money, and that means a lower interest rate. Below is a list of some of these factors that affect reward checking rates.
What can put downward pressure on interest rates
- Those who receive ATM fee refunds
- Those who make PIN-based debit card purchases
What can help banks offer higher interest rates
- Those who overdraft their accounts (This will go down due to new regulations)
- Those who fail to meet the monthly requirements
- Customers who use the banks for loans and other services
The references below can provide some more insights into the math behind reward checking:
- The Math Behind Reward Checking
- BancVue's marketing brochure for banks
- Bank CEO explaining reward checking to regulators (starts at page 10)
If you don't care about the math and just want the high rates, please refer to the reward checking section of DepositAccounts.com which lists the best reward checking accounts that are available nationwide and for your state.