What is a Savings Account?

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Definition:

A savings account is a type of deposit account that lets you keep your money safe while earning interest.

🤔 Understanding savings accounts

A savings account is a common type of account you can open at a bank or credit union. It lets you store your money for the future while earning interest. Unlike a checking account, a savings account makes it a bit harder to spend your money on everyday transactions — You probably won’t have a debit card or checkbook to go with it, and there are limits on transfers. Savings accounts are a good place to keep money you’ll need down the line but want to access quickly, such as an emergency fund or cash for the wedding you’re planning next year. Savings accounts typically earn more interest than do checking accounts, and the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per person per institution.

Example

Let’s say you and your partner plan to buy a house in a couple of years and are slowly putting away money for the down payment. Rather than letting the money sit in your checking account, you decide to move it into a savings account. That way, you won’t feel tempted to spend it on impulse purchases. Plus, you can earn more interest without having to put the money at risk by investing it in the stock market.

Takeaway

A savings account is like a piggy bank that gives you extra money…

As a kid, you may have saved up spare change in a piggy bank until you were ready to spend it. A savings account is like a piggy bank for adults — It’s a secure place to keep money you’ll need in the future, but you can access it if you need to. Unlike a piggy bank, savings accounts also give you a bit of extra money in the form of interest.

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How do savings accounts work?

A savings account is a financial product banks and credit unions offer that allows you to set aside money for the future while earning interest. Unlike a checking account, a savings account doesn’t allow you to easily pay for bills and purchases or make unlimited transfers. Instead, these accounts are designed to let your money sit and grow.

Savings accounts generally pay more interest than checking accounts do. When you put money into a savings account, you’re essentially lending your bank money. The bank turns around and lends your money to other customers, who repay their loans with interest. The bank then pays you interest for the privilege of using your money.

Savings accounts can be an effective way to save for the future while also earning a bit of extra money. For money you’ll need within the next few years, savings accounts can be a less risky way of increasing your earnings than other options, like investing in stocks and bonds. Savings accounts at qualified financial institutions are insured by the Federal Deposit Insurance Corporation up to $250,000 per bank per customer per type of account. So if you’re keeping your money in a savings account, you know you won’t lose it.

What are the types of savings accounts?

Depending on your savings goals and the financial institutions at which you bank, there are several types of savings accounts you might open:

  • Traditional: Just about every bank or credit union offers a traditional savings account that earns a small amount of interest each year.
  • Joint: Most financial institutions allow two or more people to own a joint savings account. These are often a good option for couples or for a parent and child.
  • High-interest: Most savings accounts at traditional banks offer pretty low interest rates. Online banks, such as Ally Bank and Discover Bank, often have higher-interest savings accounts and lower fees than brick-and-mortar banks. They’re able to offer these perks since they have less overhead.
  • Promotional: Some banks encourage new customers to sign up for savings accounts by offering rewards. For example, a bank may offer a $300 bonus for maintaining $3,500 in the account for three months.

What are the pros and cons of savings accounts?

Savings accounts can be an effective way to save money for emergencies and financial goals in the next few years. Keeping funds in a savings account, instead of a checking account, can discourage you from impulsively spending them on something else.

Another advantage of savings accounts is that they usually pay interest. So it can be a great way to make a few extra dollars on money you were planning to save anyway. Savings accounts usually have compound interest, meaning when you earn interest, it stacks on top of your principal and also earns interest — This helps your money to grow faster.

Unlike stocks or bonds, savings account deposits are insured by the Federal Deposit Insurance Corporation, and you don’t risk losing them in a market downturn. You can easily access the funds anytime without paying penalties, unlike a certificate of deposit (CD) or some annuities.

Savings accounts aren’t without downsides, though. You can only withdraw money from your savings account six times a month using convenient methods like online transfers (in-person transactions don’t count). You usually can’t spend money or pay bills directly from this account. Also, cash kept in a savings account is likely to lose value in the long term due to inflation.

Is a savings account worth it?

Whether a savings account is worth it depends on your goals. If your aim is to save money for a financial emergency or big purchase in the next couple of years, then a savings account can be an effective tool to do that. If your goal is to grow wealth for the future, then a savings account might not be the best option.

Many savings accounts don’t pay an interest rate high enough to keep up with inflation (in 2019, the US inflation rate was 1.8 percent). So if you’re saving the money today and spending it 10 years from now, you may actually lose purchasing power.

Historically, interest rates for savings accounts have also not kept up with stock market returns in the long run. In the decade leading up to April 2020, the S&P 500 index saw average annualized returns of more than 11 percent, not accounting for inflation. So when it comes to saving for long-term goals like retirement, it might be worth looking into other investment options.

How do I open a savings account?

Opening a savings account is easy, and you can do it either in person or online. First, choose the financial institution where you want to open your account. If you want to earn higher interest, you may want to look specifically for an online savings account.

Then, decide whether you want your own account or a joint one. To open your account, you’ll need to provide your name, contact information, address, and Social Security number. Depending on the bank, you may have to make a deposit right away to meet a minimum balance requirement or pay a monthly fee.

How much money should I keep in my savings account?

There’s no hard and fast rule for how much money to keep in your savings account. There are several reasons you may want to beef up your savings account. First, since savings accounts earn interest, you may want to maximize your earnings by keeping more money there.

You also want to make sure you’re putting away enough money for a financial emergency, like unexpected car repairs, medical bills, or losing your job. Most financial experts recommend setting aside three to six months of living expenses in an emergency fund.

On the other hand, you don’t want to keep too much money in your savings account. Federal rules limit convenient withdrawals, like those done online or through a mobile app, to six per month. If you’ve exceeded that number, you can still withdraw money in person at the bank.

Another reason not to keep too much money in savings is the lack of return you’ll see on that money. If your intention with setting money aside is to grow your wealth, a savings account may not be the best way to do that in the long term. Savings accounts often have interest rates that fail to keep up with inflation and that are lower than other investment options.

How do I maximize savings in a savings account?

If you’re going to keep your money in a savings account to earn interest, you may want to maximize the amount of interest you can earn. That means shopping around for a competitive interest rate. Many banks have very low interest rates, but others — often online banks — tend to offer higher rates. As of May 2020, the rates for online accounts went as high as 1.61 percent. Keep in mind that interest rates change — There’s no way to guarantee your account will pay the same rate in the future.

You can also maximize your savings by finding ways to stash away more money. Reducing your expenses or increasing your household income can leave a little more wiggle room in your budget, which might allow you to put more money into savings. Setting up automatic transfers to your savings account can be an effective way to allocate money to savings regularly.

How do I calculate interest for my savings account?

There are a few different ways to figure out how much interest you’ll earn from your savings account.

First, you can use a simple interest formula. Calculating simple interest is just a matter of multiplying the amount of money in your savings account by your interest rate. Suppose you had a savings account with $500 in it and a 2 percent APY (annual percentage yield). Using the simple interest formula, you earn $10 in interest.

But that’s not how savings accounts usually work. Instead, savings accounts have compound interest, which is when the interest you earn adds to the principal amount. Next time you earn interest, you’ll earn it on your principal plus the interest you’ve already amassed.

For that calculation, we’ll use the following information:

  • The account value after one year (A)
  • Your principal amount (P)
  • The interest rate (r)
  • The number of compounding periods (n)
  • The amount of time in years (t)

The formula looks like this:

A = P ( 1 + r/n ) ^ nt

Now let’s plug in the information from our previous example. You have $500 in your account with a 2 percent interest rate. Let’s say that the interest compounds monthly, and you’re calculating the amount you’ll earn in a year. Using the formula, you’ll get:

A = 500 x (1 + 0.02/12) ^ 12 x 1 A = $510.09

Most people probably don’t want to do complicated math to figure out how much interest they’ll earn from a savings account. Luckily, there are plenty of online compound interest calculators that can help.

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