Where Do Bank Interest Rates Come From?

We all know what investing means – it means putting your money somewhere where you will be able to watch it grow without touching it. On the one hand this keeps it safe – keeping it under your bed will mean that it doesn’t grow in value and eventually this will mean that it doesn’t increase along with inflation – eventually you will find that your money has very little value. At the same time keeping it under your bed would look like tax evasion and likely get you into legal trouble, and would furthermore mean your money was vulnerable to being destroyed – in the case of a house fire for instance; or stolen in the case of a burglary.

At the same time investing your money means putting it somewhere where it should get bigger and that means that you are making the most of your money. The great thing is that interest on your money is cumulative and self-perpetuating. In other words the longer you invest your money for, the larger the sum grows and so the more money you make. This is because any interest is usually added onto that lump sum of capital meaning that you are technically investing more over time – as the interest is calculated as a percentage of your original amount this means that you are guaranteed to earn more and more as time goes on.

For most of us though investing means simply putting our money into a bank account and then getting the interest rates from that. When you put your money into a bank it is kept safe and it will grow over time making it a smart investment – but have you ever thought about how your lump sum grows when it’s in a bank?

The answer is simple – banks invest your money for you. Thus if you put your money into a bank, they essentially borrow that money while it’s in there and use it to invest in businesses, in properties and in everything else. Then as the value of those businesses and those properties go up, so does the value of your money – your cut of that investment. The more money you put in to the bank, the more you get out.

The good news is that you can withdraw your money – with the interest it has accrued – at any time. This is simply because the bank has so many people’s money in there that unless everyone withdrew all their cash at once, they would still have enough money to pay each individual. However that said for very large investments the bank would still be in trouble if people took out too much money and that’s why they offer incentives for you not to. You will notice for instance that those accounts that offer the very best interest rates are the ones that don’t let you access them on a whim and don’t let you set up direct debits – for instance ISAs and savings accounts.

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