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How online banks can afford to pay high yields

By Jim Wang · Bankrate.com
Monday, July 26, 2010
Posted: 1 pm ET

Have you ever wondered why a high yield savings account at ING Direct or Ally Bank can pay interest rates that are 10 to 20 times more than your local brick and mortar? When your local bank offers 0.01 percent APY on your savings account and an online bank offers 1.5 percent APY, it seems like the two are playing under two totally different sets of business rules, right? In fact, the difference is sometimes so great it looks too good to be true!

When ING Direct first opened its doors almost 10 years ago (ING was FDIC insured on Aug. 4th, 2000), a few people thought it was a scam. Here was a virtually unknown bank offering rates that were several times that of your local bank. It was FDIC insured, which meant your assets were protected by the federal government, but people were wary. Even today, many people don't understand why they can offer such high rates, but I can explain.

Online banks are extremely efficient. They have a much lower overhead because they don't operate bank branches, don't hire nearly as many employees, rely heavily on automated online tools, and pass along some of those savings as additional interest to their depositors.

At many online banks, you can open multiple accounts online without ever having to speak to a human being. I have my CD ladder setup at Ally Bank and I opened a dozen CDs in the span of about 15 minutes using only their online interface. I save myself the time of going down to a branch and filling out 12 forms, Ally Bank saves money by not hiring a teller to process my paperwork and keeping the lights on in the branch. That's why they, and many other online banks, are almost always at the top of the interest rate charts.

As long as a bank is FDIC insured, and you can confirm this with the FDIC directly, you don't have to worry about whether or not your money is safe. If you've ever been curious how online banks can afford to pay such high rates, now you know!

Jim writes about personal finance at Bargaineering.com.

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