Bearing defects are one of the most important mechanical sources for vibration and noise generation in machine tool spindles. In this study, an integrated finite element (FE) model is proposed to predict the vibration responses of a spindle bearing system with localized bearing defects and then the sensor placement for better detection of bearing faults is optimized. A nonlinear bearing model is developed based on Jones' bearing theory, while the drawbar, shaft and housing are modeled as Timoshenko's beam. The bearing model is then integrated into the FE model of drawbar/shaft/housing by assembling equations of motion. The Newmark time integration method is used to solve the vibration responses numerically. The FE model of the spindle-bearing system was verified by conducting dynamic tests. Then, the localized bearing defects were modeled and vibration responses generated by the outer ring defect were simulated as an illustration. The optimization scheme of the sensor placement was carried out on the test spindle. The results proved that, the optimal sensor placement depends on the vibration modes under different boundary conditions and the transfer path between the excitation and the response.