What Is a Savings Account?

Savings Account Definition

A savings account is a type of interest-earning bank account that usually provides a higher return than a checking account but is slightly less accessible. Many savings accounts come with a limit of six withdrawals or transfers per month, though withdrawals via bank teller or ATM are excluded from this number.

How Savings Accounts Work

Savings accounts work by providing a safe place for people to put their money and earn interest over time.

1. Money is deposited: An initial sum of money is deposited into the savings account.
2. The deposit begins to earn interest: Once your money is deposited, it starts to accrue interest. The interest rate, typically fixed, determines how much additional money your deposit will earn over time.
3. The interest compounds based on the account schedule: Interest can compound daily, monthly or quarterly, depending on the account’s schedule. At the predetermined time interval, the interest you earn is added to your account balance. Future interest accrues based on the new total.
4. Fees are charged for maintenance and penalties: Savings accounts may have fees for account maintenance, such as monthly service charges, and penalties for exceeding transaction or withdrawal limits. Understanding these fees will help you manage your account effectively and avoid unnecessary costs.
5. FDIC/NCUA insurance protects your money: Savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA) up to $250,000. So, even if the bank or credit union fails, your money is protected.

Types of Savings Accounts

Traditional Savings Account: This is a basic account, which allows you to deposit and withdraw funds while earning interest on the balance.

High-Yield Savings Account: These accounts typically offer higher earnings than regular savings accounts. They can pay an interest rate that is 10 times the national average. However, there may be additional requirements such as maintaining a relatively high minimum balance, receiving direct deposits, or having a linked account at the same institution.

Money Market Account: Money market accounts often offer relatively high interest rates. But they usually limit the number of transactions you can make by check, debit card, or electronic transfer. Additionally, they may require a minimum balance.

Certificate of Deposit (CD): A CD is a time-bound savings account. You agree to keep your money invested for a specific period, ranging from a few months to several years. In return, you earn a fixed interest rate that is typically higher than the return offered by regular savings accounts. If you withdraw funds before the maturity date, you may incur penalties.

Individual Retirement Account (IRA): An IRA is an account that allows people to save for retirement with tax-free growth or on a tax-deferred basis.

Health Savings Account (HSA): An HSA is a savings account that helps people with high-deductible health insurance plans save for medical expenses. Contributions are tax-deductible, and withdrawals for qualified medical expenses aren’t taxed.

Education Savings Account (ESA): Also known as a Coverdell ESA, these accounts give parents and guardians a way to save for a child’s education expenses. Contributions are not tax-deductible. However, earnings and withdrawals for qualified education expenses are not taxed.

529 Plan: A 529 plan is a savings account designed for education expenses. It offers various investment options. Earnings and withdrawals for qualified education expenses are not subject to taxes.

How to Open a Savings Account

1. Research and Compare: Start by researching different banks and other financial institutions that offer savings accounts. Compare their account features, interest rates, fees, minimum balance requirements, and any additional benefits they provide. Also consider factors such as online banking capabilities, ATM access, customer service, and the institution's reputation.
2. Choose the Best Option for You: Select the bank or credit union that best meets your needs and preferences based on your research.
3. Gather the Required Documents: Typically, you will need to provide certain documents with your personal information to open a savings account. Common requirements include proof of your identity and proof of address. Some banks may also ask for your Social Security number.
4. Visit the Bank/Credit Union or Apply Online: Depending on the financial institution's policies, you can either visit a branch in person or apply online.
5. Review the Account Terms and Conditions: Read and review the terms and conditions of your savings account. Pay attention to details such as interest rates, fees, withdrawal limits, and any special conditions or restrictions associated with the account.
6. Complete the Application: Whether in person or online, you will need to complete and submit an application form.
7. Fund Your Account: Once your application is approved, you will need to deposit funds into your savings account. The bank may require a minimum initial deposit. You can typically deposit funds by cash, check, or electronic transfer.

How Much Should You Keep In Savings?

You should generally aim to keep at least three to six months of living expenses in your savings account, plus extra for specific goals. Note, it’s best not to keep more than $250,000 in a single savings account because the FDIC and NCUA only insure up to that amount.

Steps to Determine How Much to Keep in Your Savings Account

Evaluate your emergency fund: Financial experts often recommend having an emergency fund that covers three to six months’ worth of living expenses. Assess your monthly expenses and save an amount that can cover your essential costs for at least several months. This fund acts as a safety net to help you navigate unexpected events such as job loss, medical emergencies, or major home repairs.

Outline your short-term goals: If you have specific short-term goals, such as saving for a vacation, down payment on a home, or another major purchase, determine how much you need and set aside the funds accordingly.

Define your long-term goals: Identify your long-term financial goals, such as retirement planning, starting a business, or funding your children's education. Determine the estimated costs and time frames for each goal. Then allocate a portion of your savings toward these long-term goals and regularly review and adjust your savings plan as you progress toward each of them.

Weigh the risk vs. reward: While it's important to keep an adequate amount in savings, it's also essential to consider the opportunity cost of holding money in a low-interest savings account. If you have a surplus beyond your emergency fund and short-term goals, you might explore other investment options that provide potentially higher returns.

Pros and Cons of a Savings Account

Pros of a Savings Account

• Provides Liquidity: Savings accounts provide easy access to your money. You can typically withdraw funds from ATMs, through over-the-counter transactions, or via electronic transfers. This liquidity makes savings accounts suitable for short-term savings goals or emergency funds.
• Earns Interest on Your Money: One of the primary advantages of a savings account is that your money can earn interest. While interest rates on savings accounts tend to be lower than other investment options, such as stocks or bonds, they still provide a secure way to grow your money over time. The interest earned is typically added to your account balance periodically, helping your savings grow faster.
• Keeps Money Safe: Savings accounts are typically offered by banks and other financial institutions that are regulated and insured.
• Helps with Goal-Oriented Savings: Savings accounts are an excellent tool to reach specific goals. Whether you’re saving for a down payment on a house, a dream vacation, or a major purchase, having a dedicated savings account can help you track your progress and separate your savings from your daily spending money.
• Easy to Open and Maintain: Opening a savings account is relatively straightforward and doesn’t require a large initial deposit. Most banks offer online service options, making it convenient to set up and manage your account from anywhere. There are also banks that do not charge monthly maintenance fees, making them even more cost-effective.

Cons of a Savings Account

• Low Interest Rates: Savings accounts generally offer lower interest rates compared to other investments. This means the growth of your savings over time may be relatively slow, especially when inflation rates are high. If your goal is to maximize your returns, you may need to explore alternative investment strategies.
• Inflation Risk: Inflation erodes the purchasing power of money over time. If the interest rate on your account is lower than the inflation rate, your savings may not keep up with rising prices. This means that the real value of your money may decline. To combat inflation risk, it’s important to consider investment options that have the potential to outpace inflation.
• Opportunity Cost: By keeping a significant amount of funds in a savings account, you may miss out on potential opportunities for higher returns elsewhere. If you have long-term financial goals or are willing to take on some risk, investing in stocks, bonds, or other financial instruments may provide better growth potential.
• Limited Access to Funds: While savings accounts offer liquidity and easy access to your money, some banks impose restrictions on the number of withdrawals you can make per month. If you exceed these limits, you may incur penalty fees. This isn’t advantageous if you require frequent access to your funds or need more flexibility.
• Minimum Balance Requirements: Some savings accounts may have minimum balance requirements to avoid fees or qualify for higher interest rates. If you fall below the minimum balance, you may be subject to fees or receive reduced interest rates.
• Potential Fees: While there are some banks that do not have monthly maintenance fees, many large financial institutions charge them. In addition, certain transactions or services may cost you. For instance, excessive withdrawals beyond the allowed limit or using non-network ATMs may result in additional charges. It’s important to review the fee structure of your specific savings account.

How to Maximize the Return From a Savings Account

Research Interest Rates

Compare interest rates offered by different banks and other financial institutions. Look for accounts with higher interest rates, as even a small difference can lead to increased earnings over time.

Use High-Yield Savings Accounts

Explore high-yield savings accounts, which typically offer a better return than traditional savings accounts. These accounts may have certain requirements, such as higher minimum balances or limited transaction options, but they can help boost your earnings.

Consider Online Savings Accounts

Online banks often have lower overhead costs than traditional brick-and-mortar banks, allowing them to offer higher interest rates. Focus on reputable online banks that provide the best rates.

Take Advantage of Compound Interest

Compound interest allows your savings to grow faster. More specifically, your principal investment earns interest, then that interest is added to the principal amount, and subsequent interest accrues based on the new total. This can exponentially increase your return. So, instead of withdrawing the interest you earn, it’s best to keep it in the account.

Automatically Transfer a Portion of Your Income

Set up automatic transfers from your checking account to your savings account. By automating the process, you ensure consistent savings and reduce the temptation to spend the money.

Maintain the Minimum Balance

If your savings account has a minimum balance requirement, make sure to maintain it to avoid fees and earn higher interest rates. Falling below the minimum balance might result in a reduction in interest rates or additional charges, which can eat into your earnings.

Regularly Review and Compare Accounts

Keep track of your savings performance and periodically review other account options. Interest rates and account features can change, so it's beneficial to stay informed and consider switching to a better account if it aligns with your goals.

Diversify Your Investments

While savings accounts provide stability and liquidity, they may not be the sole way to maximize your earnings. Consider diversifying your investments by exploring your other options such as stocks, bonds or real estate. Diversification allows you to potentially earn higher returns while managing risk.