By Jonathan Stempel

(Reuters) -A federal judge rejected Capital One's $425 million settlement with depositors who said they were cheated out of high interest rates, saying the payout was too small and millions of account holders would continue to be short-changed.

The class action settlement was intended to resolve claims that Capital One froze rates at 0.3% on its "high interest" 360 Savings accounts, while quietly offering rates above 4% to new customers on similarly named 360 Performance Savings accounts.

Capital One, based in McLean, Virginia, agreed to pay $300 million of unpaid interest to 360 Savings depositors, plus $125 million of interest if they still held their accounts.

But in a decision on Thursday, U.S. District Judge David Novak in Alexandria, Virginia said the strength of the plaintiffs' claims justified "significantly greater relief."

JUDGE SAYS HARMS WOULD CONTINUE

The judge said the accord appeared to provide 360 Savings depositors less than 10% of their damages, and leave them stuck in the low-yielding accounts while 360 Performance Savings depositors earned four to eight times more.

"These millions of class members would continue to experience the same financial harm that they have already experienced for years," Novak wrote.

The judge ordered both sides to resume settlement negotiations in order to address his concerns.

Capital One did not immediately respond on Friday to requests for comment. Philip Black, a lawyer for the plaintiffs, declined to comment.

NEW YORK, 17 OTHER STATES OPPOSED SETTLEMENT

Eighteen states including New York, which is suing Capital One over the same issue, opposed the settlement.

They estimated that 360 Savings depositors would earn an effective 0.78%, compared with 3.4% that 360 Performance Savings depositors now earn, saving Capital One more than $2.5 billion.

A spokesman for New York Attorney General Letitia James had no immediate comment.

The U.S. Consumer Financial Protection Bureau also sued Capital One over the 360 Savings accounts, but dropped the case as the agency largely ended its enforcement activities.

The case is In re Capital One 360 Savings Account Interest Rate Litigation, U.S. District Court, Eastern District of Virginia, No. 24-md-03111.

(Reporting by Jonathan Stempel in New York; Editing by Bill Berkrot)