It's Not Legal for Checking Accounts to Pay Interest
The United States government prohibited banks from paying interest on checking accounts under Section 11 of the Banking Act of 1933, sometimes referred to as The Glass-Steagall Act. It was referred to as Regulation Q. The fact that it's actually illegal to have an interest bearing checking account may leave you scratching your head – particularly if you HAVE a checking account that earns interest! When these regulations went into effect, banks created alternatives to the checking account, like money market funds and Negotiable Order of Withdrawal account (NOW).
Both the money market account and NOW account allow account holders to write checks against the money in the account – but are not consideredto be a checking account and therefore banks can pay interest on them.
Interest Bearing Checking Accounts
While many financial institutions (banks and credit unions) advertise their interest bearing checking accounts – the term is actually incorrect or a bit misleading. Any financial institution offering an interest bearing checking account is really offering either a Negotiable Order of Withdrawal or a money market account. They pay interest on the deposits in the same way that savings accounts do, but the account holder is able to write checks against the money in the accounts. Interest-bearing checking accounts may not be covered by the FDIC and insured the way your regular non-interest checking account would be, so make sure you check with your banking institution to determine whether or not the funds in your interest-bearing “checking account” are covered in the event of a bank failure.
In fact, if you read the disclosures of an interest-bearing checking account, chances are you'll discover something similar to the following – because while you can write checks, they are not technically a checking account:
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Are Not FDIC Insured
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Offer No Bank Guarantee
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May Lose Value
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Are Not Insured by any Federal Government Agency
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Are Not A Deposit
Negotiable Order of Withdrawal Account (NOW)
NOW accounts were created by the former President and CEO of the Consumer Savings Bank in Worcester, MA, Ronald Haselton. They are considered a liability from the bank's perspective, and are considered to be “checkable deposits”.
Investopedia describes a NOW account as: “An interest-earning bank account with which the customer is permitted to write drafts against money held on deposit”.
It was during the depression-era that people began to think checking accounts that earned interest were contributing to the increased numbers of bank failures. Banks during the depression were luring people away from other banks by offering more attractive interest rates on checking accounts and as banks lost their customers and the money of those customers – they would go under and declare bankruptcy.
The Glass-Steagall Act banned payment of interest on checking accounts, which resulted in creativity from banking institutions in the creation of other deposit products that could earn interest legally. Passbook savings accounts and regular savings accounts did not have ceilings placed on interest earnings – and these accounts allowed customers to deposit money or withdrawal money during the bank's business hours.
In 1972, the President and CEO of the Consumer Savings Bank in Worchester, Massachusetts created the first NOW account. The Consumer Savings Bank of Massachusetts was a mutual savings bank insured by the state insurance fund rather than the federal insurance funds– which meant it was independent from regulations imposed on federally insured financial institutions. Once the NOW account was used in Massachusetts, it spread to the rest of New England, New York and New Jersey. Technically, NOW accounts are not “checking” accounts, but they do allow you to write checks against your deposits.