For an investor, a saver, the cash holder – namely, anyone who values a dollar – interest rates are important. For the person with money to spare, it's what they can earn if they invest or save their money. But interest rates are also important to credit seekers. For them, it's what they must pay to borrow money for a set period in exchange for a promise to repay the cash sometime in the future.
The factors that influence the interest a borrower must pay, or a lender will earn, are many. One major factor is an account's interest rate. Most people are familiar with short- and long-term rates. The tiered interest rate may be less well known than are those two, but it's no less important to financial decision-making.
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What Are Tiered Interest Rates?
A tiered interest rate is an interest rate that varies depending on the status of an account, such as the account's cash balance. For instance, a tiered interest rate schedule may be associated with a savings or a money market account. The Federal Reserve influences the reserves market and the federal funds rate, each of which influences short-term interest rates, such as those paid on the cash in a money market account.
Typically, the tiered interest rate schedule applies to accounts for which the balances from one account to another may vary widely. For instance, a tiered-rate bank account's interest rate may increase as the amount of the account's balance rises.
The Tiered Rate Schedule
The tiered rate schedule grants a higher interest rate to the account owner with the larger account balance. The larger the balance, the higher the interest rate. In this way, the tiered rate serves as an incentive for the account holder to maintain a large balance.
The tiered rate schedule may also serve to attract and retain customers, a process that's essential to the profitability of a financial institution in that the institution lends deposits to earn interest on the loans.
Tiered Interest in Practice
Assume that Larry is a depositor at ABC National Bank. Larry has an ABC savings account with tiered interest rates whereby he earns a variable interest rate, which will fluctuate over time according to his account balance. The account agreement states that to earn 6 percent interest, Larry must continue to maintain a $10,000 balance. Should he deposit additional money in the account that pushes him to the next tier in the structure, he'll earn an even higher interest rate.
Read More: 7 Kinds of Interest Rates
Tiered Interest Structure and Bank Revenue
Because a primary source of ABC's income is lending out the money their customers have deposited with them, the bank offers competitive rates on those deposits as reflected in the tiered interest structure. The bank's objective is to earn a higher interest rate on loans than what they will pay their depositors. The difference between the interest payments made to depositors and interest rate that ABC charges its borrowers is the net interest margin, which is a key bank profitability metric.
A financial institution may pay five different rates of interest on money market accounts, each one associated with account cash balances – the deposit amounts – in a certain dollar range. The bank might pay the lowest interest rate of the tiered interest schedule for cash balances between the minimum account balance of $100 and $2,500. The interest rate increases along with the required cash balance until it reaches the top interest rate of 6 percent for account balances of $500,000 or more.
Read More: Types of Bank Accounts and Their Rates of Interest
The financial institution might have conditions in addition to the dollar value of the account balance that govern the interest payments defined in the tiered interest schedule. For instance, a bank may require that a minimum daily balance be maintained or that the number of your bank account transactions be less than a certain number. Should you exceed the latter, the bank charges you a fee that, in part, offsets the interest the institution pays you for your deposit.