What is a savings account? Definition, how they work
What is a savings account?
A savings account is a basic type of financial product that allows you to deposit your money and typically earn a modest amount of interest. These accounts are federally insured up to $250,000 per account owner and offer a safe place to put your money while earning interest.
You can find savings accounts at banks and credit unions. You don’t need a large amount of money to open a savings account, and you also have easy access to your money.
Why you need a savings account
A savings account is a good place to keep money for a later date, separate from everyday spending cash, because of their safety, reliability and liquidity. These accounts are a great place for your emergency fund or savings for shorter-term goals, like a vacation or home repair.
Beyond quick access to your cash when you need it, savings accounts often offer higher interest rates than checking accounts. You might even find some savings accounts with a higher APY than money market accounts. The average APY on savings accounts is just 0.06 percent, but you can find high-yield savings accounts paying around 0.6 percent.
Finally, there are many opportunities to open a savings account with low fees. You can often find simple options to avoid pesky maintenance fees.
How does a savings account work?
You will open a savings account at a bank or credit union, either online or in person. The process is similar to opening a checking account. You will provide the institution with personal information and then deposit money into the account.
Once you’ve made a deposit, the money in your savings account will begin to earn interest. The amount you earn will depend on a few factors, including your savings account APY, the amount of money you deposit and how long you keep money in your account.
Your bank may choose to compound interest on a daily, monthly, quarterly or yearly basis. At the end of each compounding period, your accrued interest is deposited into your account. From there, your new account balance (deposits plus interest) will begin earning interest.
For example, let’s say that you made an initial deposit of $10,000, and your bank compounds interest annually. With an 0.06 percent APY, you’d earn about $6 in interest for the year. However, with a high-yield savings account APY of 0.6 percent, you’d make about $60 for the year. Then, your new balance (either $10,006 or $10,060) would start to earn interest. If you have a shorter compounding period, your money will grow even faster.
Your savings account APY is variable and can change at any time. You can move money out of the account whenever you want, but Regulation D limits the amount of times you can do so to six per month.
How much should you keep in your savings accounts?
The amount of money you should keep in a savings account largely depends on your goal. If you’re using it as an emergency fund, most financial advisors suggest that you keep three to six months’ worth of living expenses in your account.
For example, if you spend an average of $3,000 per month on costs such as your mortgage, car payment and food, you would save anywhere from $9,000 to $18,000 in the account.
You can use a simple savings calculator to calculate your savings and see how long it might take you to save for a specific goal.
Can you lose money in a savings account?
You’ll never lose the money you have saved — up to the FDIC insurance limit of $250,000 per account owner at FDIC-insured banks. But the money in your savings account can lose purchasing power over time. For example, if someone earns 0.2 percent APY on their savings account and inflation is at a 2 percent annual rate, they’d face a 1.8 percent decline in purchasing power over a year.
According to Bankrate data, the average interest rate for savings accounts nationally is just 0.06 percent. You can open a high-yield savings account to earn a higher APY, but you’ll still be missing out on the potential investment returns offered by higher-risk investments, such as mutual funds, stocks and bonds.
Find the right balance of cash to store in your savings account. You want to keep enough on hand to deal with any emergencies. But you don’t want to overdo it and miss out on the opportunity to grow your investments over the long term.
Are online savings accounts safe?
Online savings accounts are just as safe as savings accounts at traditional institutions. As long as the institution offering a savings account is insured, your deposits are safe. Look for banks — both traditional brick-and-mortar banks and online banks — that are insured by the FDIC and credit unions insured by the National Credit Union Share Insurance Fund (NCUSIF). Both insure savings accounts up to $250,000 per depositor, per insured bank or credit union and per ownership category.
The biggest benefit of an online bank is that they typically can offer higher yields because their overhead costs are much lower than brick-and-mortar banks.
Savings accounts advantages and disadvantages
Like all financial products, savings accounts come with some pros and cons.
Here are some of the advantages of savings accounts:
- Safety: Money kept in a savings account at an FDIC-insured bank or an NCUSIF-insured credit union is insured up to $250,000 per account owner, keeping your savings safe.
- Growth: Savings accounts are generally interest-bearing, meaning you will earn interest on the money you save in the account.
- Liquidity: Though savings accounts provide a place to stash money that is separate from your daily banking needs, they still let you make up to six withdrawals or transfers per statement cycle.
Here are some of the disadvantages of savings accounts:
- Higher yields available elsewhere: The main downside is that interest rates on savings accounts may be lower than other financial products.
- Accessibility restrictions: Federal regulations restrict the number of withdrawals or transfers you can make from a savings account to six per statement cycle.
- Loss of purchasing power over time: If your savings account yield is lower than the inflation rate, you will lose purchasing power over time.
How to maximize earnings from a savings account
The average interest rate on a savings account is low. Fortunately, there are a few ways to boost your earnings:
- Check out community and online banks: Big brick-and-mortar banks typically don’t offer the returns of these institutions. Online banks, in particular, tend to offer better yields: They don’t have the costs associated with brick-and-mortar banks and tend to pass those savings on to their customers.
- Get a sign-up bonus: Some banks offer cash bonuses when you sign up for a new savings account. These bonuses can range in the hundreds of dollars. It’s worth keeping an eye on the best bank account bonuses and signing up for an account with a great bonus and a great rate.
- Shop at credit unions: A credit union may offer you a better yield than you can find elsewhere. These not-for-profit organizations are member owned and tend to offer high rates and low fees.
- Rely on the power of compound interest: Savings accounts offer liquidity, but your money will grow faster the less you touch it. You can use a compound interest calculator to see how small deposits into a savings account quickly add up over time.
- Watch out for fees: Some savings accounts advertise an attractive rate, but they come with fees that can eat into your interest rate. Do what you can to avoid incurring fees on your savings account. Better yet, shop for an account with very few fees.
How to open a savings account
Opening a savings account is simple. Here’s how to do it:
- Think about your savings goals: For example, you may want to build an emergency fund or save for a vacation. Knowing your goal will help you decide which savings account is best for you.
- Shop around – at more than just big banks:. Online banks, credit unions and community banks tend to offer more competitive interest rates than large retail institutions. And don’t forget to look at monthly maintenance fees, minimum balance requirements and transaction fees.
- Confirm the account is insured: Check to make sure the account is insured by the FDIC if it’s a bank or the NCUSIF if it’s a credit union.
After choosing a savings account, the way you set it up will vary by bank or credit union. Either way, you’ll need to provide some general documents and information, including a driver’s license or state ID, your Social Security number, address, date of birth and other personal info.
Ready to open a savings account? Here’s a step-by-step guide.
Other types of deposit products for savers
Savings accounts aren’t your only option when it comes to federally insured places to keep your money. There are other savings products offered by both banks and credit unions that are low-risk, liquid and interest bearing.
- Money market accounts: Money market accounts can provide higher rates than savings accounts, but they may have higher minimum balance requirements. Like a savings account, withdrawals and transactions are limited to six per billing cycle. These accounts may come with an ATM card and checks.
- Certificates of deposit: CDs are time-deposit accounts. They hold your money for a specific period of time. In exchange, they pay a guaranteed yield that’s generally higher than savings or money market accounts. The trade-off for the higher yield is that there is no liquidity (without penalty) for an agreed upon period of time, which can range from a few weeks to years. Unless you have a special type of CD, you’ll have to keep your money locked away for the duration of the term. If you withdraw cash early, you can get hit with a penalty that can eat up all of your interest earned and some of your principal.
Want to compare your options? Explore money market accounts, certificates of deposit, and savings accounts today.