UPDATED: March 16, 2022
Table of Contents
What is a Savings Account?
A savings account is a safe place to park your money and earn interest. In simple terms, it is a bank-offered product that allows individuals to store money while earning interest on their contributions and account balance.
A savings account is safe and reliable, which makes it a good place to keep your cash that you want to have available for short-term needs - much safer than a shoe-box under the bed.
Banks, credit unions, and other financial institutions will pay a modest interest rate on the money you have in your savings account.
Unlike other investments, such as stocks, a savings account is insured by the federal government, also known as the Federal Deposit Insurance Corporation or FDIC. If your savings account balance is equal to or less than $250,000, you are fully insured if the bank fails, which means there is no risk of you losing the money you have within the account.
Savings accounts have certain limitations on how often you can withdraw your money, but they also provide exceptional flexibility. A savings account can be a great option to establish an emergency fund, create short-term goals/milestones you want to achieve, or just keep extra cash you’re not currently investing.
How Do Savings Accounts Work?
An individual can set up their savings account at their local bank, credit union, or even through online only banks. The account owner deposits money into this FDIC insured account and the bank will pay you an annual interest rate on the money you keep within this account.
In return, the bank uses that money by loaning it out to other people via mortgages, car loans, personal loans, etc. The bank earns a higher interest on these loans vs. what it pays out to savings account owners, which is how the bank makes money.
At any time, the savings account owner may go to their bank and withdraw their funds in the form of cash.
- You sign up for a savings account at your local bank, credit union, or online bank
- Money in a savings account can be easily accessed and converted into cash
- The bank pays you interest on the amount that you’ve deposited
A savings account will typically have a $25 minimum balance. If the account dropped below $25, the account owner might be charged a fee. There is no upper limit as to how much money you can keep in a savings account, but remember, the FDIC only insures accounts equal to or less than $250,000.
How Interest Works on Savings Accounts?
An interest rate is viewed as a percentage. This is essentially the amount of money a bank pays for having a savings account with them. If the bank is paying a 1% APR (annual percentage rate), you will earn $1 for every $100 you have deposited in this checking account.
Interest rates also compound. Using the above example, in year one you have $100 and earn $1 in interest. In year two, you earn 1% on $101. Although this could add up with higher dollar amounts, a savings account shouldn’t be treated as a wealth building vehicle.
Those seeking a greater return, or interest rate, should consider consulting with a financial advisor to determine which financial vehicles are best suited for their goals, risk level, and life circumstances.
A higher interest rate could generate a greater return, but that also comes at risk and potentially limitations. Certificates of deposits, or CD’s, typically have a greater interest rate when comparing them against a savings account, but the money you put into a CD isn’t nearly as accessible, or liquid.
A savings account isn’t designed to be a ‘get rich’ account. It is designed to preserve and protect the cash you have.
Where Can You Open a Savings Account?
There are many places you can go to set up a savings account. These options include:
Banks (including local and big banks)
Any large national bank, or local community bank, will offer their customers the options to set up a savings account. The large bank may have some fees associated with managing the account, such as a minimum account balance fee, or yearly fee if the account value is not over $X.
However, community banks typically have a friendlier approach to their fees and requirements.
A credit union is a customer-owned institution that offers many of the services a typical bank will offer. However, credit unions tend to have the most consumer friendly banking options, offering little to no fees on their accounts, and may even offer a slightly better interest rate on their savings account.
Credit unions will certainly offer their members an option to establish a savings account.
Online Banks & Credit Unions
Online banks are becoming increasingly more popular. These banks do not have any physical location you can visit, but due to their lower operating structure, they offer very competitive rates on their accounts.
If you’re comfortable banking from your phone or laptop, you may be interested in exploring the various online only banks. You can manage your money from the comfort of your home. One of the downsides is the ease and accessibility to withdrawal cash. It of course is still possible, but there may be various restrictions or requirements.
Savings Account Advantages
If you have extra money left over that you’re not using to pay the bills, or that’s not tied up in another investment, you should consider opening a savings account. There are many advantages associated with having a savings account.
Earn an Interest Rate - Although the interest rate on a savings account won't make you rich, it is still better than just sitting on that money in cash at your home tucked under your mattress!
Any opportunity to earn money while you’re sleeping is certainly worth exploring. Sure, instead of going under your mattress for the money you may need to drive 5 or 10 minutes to the bank, but the safety, security, and interest this provides makes it well worth it.
Liquidity: With a savings account, your money is readily available in cash. Unlike stocks or investments, you don’t have to worry about selling products or investments to get the money in an emergency event. You can walk into the bank and withdraw your money as you please. You can also use online banking to easily move funds to pay bills, fund retirement accounts, or do just about anything.
Protection: If you sign up for a savings account at a bank that is a member of the Federal Deposit Insurance Corporation (FDIC) your savings account will be insured up to a $250,000 account balance. If the bank failed or went out of business, you wouldn’t lose your money. If you’re considering banking at a credit union, make sure the credit union is a member of NCUA, which also insures savings accounts up to $250,000.
The protection is limited to $250,000, per account at any particular bank. But there is no restriction to spreading your money across numerous banks in the event you plan on keeping more than $250,000 in cash within a savings account.
Easy Access and Availability: Savings accounts are easy to set up and you can deposit money into them from numerous locations. You can take a picture of a check on your phone and deposit that money into your savings account.
You can visit an ATM and deposit money into your savings account, or you can make a cash deposit inside the bank. If your savings account is also at the bank that holds your checking account, you’ll be able to transfer funds between accounts with just the click of a single button!
Low Start-up Requirements: Most of the savings accounts require only $25 to start. Some financial institutions also allow customers to start for as little as $1.
Savings Account Disadvantages
Besides numerous benefits, signing up for savings accounts might not be the best option due to some of its common drawbacks which include:
Low-interest Rate: Although a savings account is a good place to store your money you can’t afford to lose, it is not a good place to earn a meaningful amount of interest. Other investment options, such as stock, bonds, or CD’s, can provide the investor with a significantly greater return, ultimately helping the investor generate more money.
Remember, the higher the interest rate, the greater the risk. But where there’s risk, there’s reward.
Inflation: Many savings accounts have an interest rate lower than 1% per year. Inflation tends to grow at a greater rate than 1% per year. If you’re not keeping up with inflation, you are losing purchasing power over time. This means your money will buy less in the future if it’s not keeping pace with inflation.
Temptation to Spend Money: The ease of access is one of the greatest benefits a savings account can provide. But if you aren’t disciplined, it is also a huge disadvantage. At any moment you can spend the money in your savings account on everyday item, or something that isn’t aligned with your goals.
If the money is there, fighting temptation can be hard! If you have a spending problem, consider opening a CD.
Withdrawal Limitations: In the United States, there are federal limits on the number of withdrawals you can make per statement cycle. This law limits you to only six withdrawals from each savings account during a month.
This law is known as ‘Regulation D’ and additional withdrawals (more than six within a given month) might charge you an extra fee.
Variable Rates: Savings account interest rates can change, which means that the financial institutions have the right to set and change the rates as they wish. High-interest rates of savings accounts may stay in line with the movements of the federal funds rate.
How Much to Keep in a Savings Account?
Saving money is the first step towards achieving your long-term financial goals. But the question is: How much should you keep in your savings account?
That answer isn’t black and white, nor is there a one size fits all approach. How much money you should save is different for each individual. Various factors or variables need to be reviewed before coming to the conclusion. To figure out how much you need to keep in your savings account, here are a few things to consider.
Determine Fixed Expenses
Fixed expenses are the expenses you pay each month that you can’t go without. This includes; rent, groceries, gas, utilities, and insurance. You first need to figure out how much money you NEED each month before you can figure out how much money you should have in a savings account. Many financial advisors would suggest having a 3-month cash reserve in a savings account at all times. This can be viewed as an emergency fund, and is often the first financial step you need to make to take better control over your financial picture.
Do you have any short term goals you’d like to save for? For instance, perhaps you’re saving up for a vacation, a down payment on a home, or a renovation. How much you should save is contingent on how much these short-term obligations will cost you.
Do you have a car payment, student loan debt, or are you carrying a balance on a credit card? Once your emergency fund is established, it is often advised before saving another dime you work on a debt repayment plan.
It doesn’t make sense to save $5,000 in a savings account earning a 1% interest rate when you have a $5,000 credit card balance charging you a 20% interest rate each year! Pay off your debt once your emergency account is established.
If you own a home, you may want to have a bit more in cash saved up. If the hot water heater broke, or a pipe burst, you can get that fixed without dipping into your cost of living emergency fund.
With a savings buffer, you won’t need to use a credit card, or take on debt, to pay these difficult to predict expenses when they arise.
Savings Account Interest Rate
Saving accounts typically don’t provide a phenomenal interest rate. Most major national banks have a very low annual interest rate they pay their customers each year. However, credit unions and online banks will tend to pay a higher interest rate on their savings accounts. Feel free to shop around between various financial institutions to see who is offering the most competitive rate.
Look Beyond a Savings Account
The importance of savings can’t be overstated. It is the first step to build wealth and achieve your goals but putting money in your savings account is not the only step you need to take to reach your goals. You’ll need to consider some other accounts that have the ability to yield higher interest rates.
Certificates of deposit: CDs (certificate of deposit) are a type of savings account that tends to increase at a fixed interest rate for a specific period. The length of an interest rate can vary, ranging from six months to a few years. The longer the length of the CD, the greater interest you can earn.
Interest rates on a CD are higher than the interest rates on a typical savings account. However, you cannot convert your CD into cash nearly as easily. If you did need to ‘cash in’ your CD before it’s maturity date, you’d be forced to pay a fee.
CD’s are a good option if you know you’re not going to need the money. It’s also a good way to prevent you from spending the money you have in a savings account.
Money market accounts: Unlike a traditional savings account, money market accounts come up with higher interest rates and provide checks and debit cards. However, you have easy access to your funds while using money market accounts just like a traditional savings account.
The first step to taking control of your finances is to get started. Procrastination will not take you any closer to achieving the goals you set. Many people come up short for money when they need it because they haven’t thought about saving enough money for whatever life throws at them.
A savings account is easy to access, liquid, and can get set up at your local bank, credit union, or even from the comfort of your own home via an online bank. A savings account is a great account you can use to establish your emergency account.
A savings account is a great tool to use. These accounts can help you establish an emergency savings amount, be used to set short and long term goals, and help you establish better money management practices.