Question

Making Inferences A local bank offers savings accounts that have no minimum balance requirement and pay 3 percent interest per year. Account holders can withdraw any amount of money from their accounts at any time. The bank also offers money market accounts that require a \(\$ 500\) minimum balance and pay 4 percent interest each year. Account holders are allowed two withdrawals per month, but each must be for at least \(\$ 100 .\) Why does the money market account pay a higher interest rate?

Short answer

Money market accounts pay higher interest due to higher minimum balance and restricted withdrawals, reducing bank risk.

Step-by-step solution

Understand the Account Types

The local bank offers two types of accounts: savings accounts and money market accounts. Each has different terms for withdrawals and minimum balance requirements.

Analyze Savings Account Features

Savings accounts have no minimum balance requirements and pay 3% interest per year. Account holders can make unlimited withdrawals of any amount at any time, offering high flexibility.

Analyze Money Market Account Features

Money market accounts require a \\(500 minimum balance and pay 4% interest per year. Account holders are limited to two withdrawals per month with each being at least \\)100, making them less flexible than savings accounts.

Compare Interest Rates and Flexibility

Savings accounts offer lower interest due to high liquidity and flexibility, which makes the bank's commitment easier and less risky for smaller balances. In contrast, money market accounts offer higher interest rates due to higher minimum balance and withdrawal restrictions, which reduce bank risks and allow higher returns.

Draw Conclusion

The money market account pays a higher interest rate due to the higher minimum balance requirement and withdrawal restrictions, which provide the bank greater stability and reduced liquidity risk compared to the flexible savings accounts.

Key concepts

Interest Rates

Interest rates are essentially the reward for depositing your money with a financial institution like a bank. They are a percentage of your deposited funds, paid over a specified period, usually annually. Interest rates vary between different types of bank accounts and are influenced by factors such as account terms and market conditions.
For instance, the local bank example provides two account types with different interest rates: 3% for savings accounts and 4% for money market accounts. The interest rate indicates how much extra money your deposit will earn over time.
A higher interest rate, like the one provided by money market accounts, typically comes with stricter conditions but rewards you with more earnings on your deposits. Therefore, when choosing an account, consider not just the interest rate, but also the terms that accompany that rate, such as balance requirements and withdrawal limitations.

Minimum Balance

Minimum balance is a crucial term when talking about bank accounts. It refers to the minimum amount of money you must keep in your account to access certain benefits, like earning interest or avoiding fees.
In our example, savings accounts have no minimum balance requirement, providing great flexibility. This means you can withdraw all your funds without penalty.
Conversely, money market accounts require a minimum balance of \( \$500 \). Maintaining this balance ensures you earn the higher interest rate of 4% per year. If the balance falls below this amount, you might not receive the same benefits or interest rewards. Thus, understanding and keeping track of the minimum balance is essential to maximize your earnings and avoid potential fees.

Account Types

The type of bank account you choose significantly impacts your financial strategy and how you manage your funds. There are generally two types in our scenario: savings accounts and money market accounts, each catering to different financial goals.
Savings accounts are straightforward and flexible. They allow unlimited withdrawals and require no minimum balance, making them suitable for daily financial needs or short-term savings. They usually offer lower interest rates due to this flexibility.
On the other hand, money market accounts are designed for slightly longer-term saving goals. They offer a higher interest rate but come with more conditions, such as a \( \$500 \) minimum balance and withdrawal restrictions. These constraints help maintain account stability and allow banks to lend the deposited funds more effectively, hence the higher interest rates. Choosing the right account depends on your unique financial needs and how you intend to use the funds.