What Is a Savings Account and How Does It Work?
In a world where people must take on numerous financial responsibilities, saving money has become more critical than ever. Savings accounts are interest-bearing bank accounts where the frequency and methods of withdrawals may be subject to limitations. Although savings accounts will probably not make you rich, they can become a valuable tool in helping you to meet financial goals.
What Is a Savings Account?
A savings account holds money that you will need at a later time, such as an emergency fund or savings for a down payment. Unlike a checking account, which is designed for frequent withdrawals and direct purchases, the purpose of a savings account is to put money aside for the future and earn interest on the account balance.
How Does a Savings Account Work?
A savings account works by growing your deposits over time with interest earned. When you fund a savings account, the bank or financial institution lends your money to other people and charges them interest. In return, the financial institution pays you interest.
In the unlikely event the bank fails, your money is protected. Savings accounts in the United States are insured up to $250,000 by the Federal Deposit Insurance Corp. or the National Credit Union Administration.
Why Do You Need a Savings Account?
You might think you don’t have enough money to bother with a savings account, but you’ve got to start somewhere. Remember, many banks don’t require a minimum deposit, so even if you can spare just $5 this month, you can start reaping the benefits of having a savings account.
Motivation To Save
A savings account encourages you to save. If you generally have an extra $100 in your checking account at the end of each month, you might want to splurge on a nice dinner or a new outfit. Instead, if you shift that money to your savings account, you’ll have $1,200 at the end of the year — plus your interest.
Build an Emergency Fund
Once you open your savings account, set an initial savings goal to build an emergency fund. Most experts recommend having three to six months of living expenses in your savings account to help counteract a job loss or other financial emergency.
Unfortunately, most people do not have anywhere close to that amount in their savings accounts. In fact, according to a GOBankingRates survey, 39% of women and 33% of men have $100 or less in their savings account.
Avoid Debt
Saving up for large purchases instead of charging them helps you build financial discipline — and that can keep you out of debt. Even if you pay off your cards each month, the simple act of charging purchases can encourage you to purchase more often. A study by MIT Sloan professor Drazen Prelec found that charging increases the pleasure of completing a purchase so much that consumers will pay up to twice as much for an item when using a credit card as they will when using cash.
How a Savings Account Can Help You Grow Your Money
A savings account is more than just a place to put your money. It also grows your money by paying you interest on your balance. Even better, the money earns compound interest, which grows the balance faster the longer you save.
Compound interest is interest earned on your deposits and on any interest those deposits have earned. If you were to deposit $1,000 at 4% interest, compounded daily, you’d earn $40.81 in interest in year one, $42.47 in year two and $44.21 in year three. Compare that to simple interest, which would amount to a flat rate of $40 per year.
The extra few dozen dollars a year in this example doesn’t look like much, but the so-called “miracle” of compound interest is that it snowballs — the longer you keep the money in your account, the faster it grows, even if you don’t make any additional deposits. If you follow the experts’ advice to develop a savings habit, you could see your savings really take off.
Saving Automatically
One strategy you might consider is automatic savings deposits right from your paycheck. Financial author and columnist Suze Orman recommends this approach. Orman says it doesn’t matter whether you contribute $10 per month or $250 or $1,000, but she insists that you contribute automatically. She considers this an excellent “set it and forget it” approach for reaching savings goals. If the money is out of sight, it’s out of mind — and less of a temptation to spend.
The amount of interest you’ll earn on a basic savings account varies widely by financial institution. It’s worth checking around to compare rates. As your savings account grows, you’ll want to achieve maximum earnings.
How Do You Open a Savings Account?
Applying for a savings account isn’t difficult. How you apply — online, in person at a branch or by phone — will depend on the financial institution you choose. No matter where you open a bank account, you’ll need to provide at least the following key information:
Government-issued identification, which can be a driver’s license or passport
Date of birth
Your address, phone number and email address
Some banks and credit unions will require a minimum deposit to open your account. Bank of America, Member FDIC, has a $100 minimum deposit for its Advantage Savings account, for example, while you’ll need an initial deposit of $25 for the Wells Fargo Platinum Savings account. Capital One’s 360 Performance Savings has no minimum opening deposit.
Other Types of Savings Accounts
The three main types of savings accounts are regular deposit accounts, money market accounts and certificates of deposit, though there are more specialized accounts as well. With different rules and investment options, some can offer higher returns without putting your money at risk. Other savings accounts offer tax benefits, and most include FDIC or NCUA insurance protection. Here are some of your options.
High-Yield Savings Accounts
A high-yield savings account pays a higher interest rate than a basic savings account. Many online-only banks offer high-yield accounts. Ally Bank, for example, is paying 4.20% APY on its savings account.
Some of the biggest banks in the nation have an APY of just 0.01%. Because they don’t have the same overhead that brick-and-mortar banks do, online-only banks can share their savings with account holders by offering greater interest payouts.
CDs
CD accounts are savings accounts with more restrictive withdrawal rules. They allow you to lock away money for a specific amount of time at a specified rate.
Although this instrument might pay a higher interest rate than a traditional savings account, early withdrawals can involve penalties. Moreover, with a lock-up period, CDs are not suitable for funds you might need in an emergency.
Money Market Accounts
A money market account is a hybrid savings and checking account. You can withdraw your funds by check or by electronic or telephone transactions. Some also offer a debit card.
A money market account pays interest, but not at as high a rate as high-yield savings accounts might offer. These are consumer deposit accounts and not investment accounts.
Cash Management Accounts
Cash management accounts are nonbank deposit accounts. For the most part, these accounts are insured through FDIC- or NCUA-affiliated financial institutions.
The features, restrictions and fees on CMAs vary. Many act as a hybrid checking and savings account, allowing you to meet expenses while earning a higher interest rate. However, those needing a degree of separation between checking and savings might not want this type of account.
Health Savings Accounts
If you are in an eligible high-deductible health plan, health savings accounts allow you to contribute up to a specific amount per year and pay for qualified medical expenses using pretax dollars. Moreover, unused funds can carry over to the next year. HSAs should also not be confused with flexible spending accounts, which are employer-controlled.
Getting a Savings Account
If you’re ready to open a savings account, the most obvious place to look is your local bank or credit union. Your financial institution of choice can quote interest rates and explain any limitations, fees and minimums that come with each savings account.
With limited funds to put away, savings accounts might not seem like they are worth the effort at first glance. However, with the opportunity for spending discipline and peace of mind, these separate accounts could provide you with a valuable tool for financial success.
FAQ
Understanding how a savings account works is the first step toward meeting important financial goals. These questions and answers will get you started.
What is a savings account and how does it work?
A savings account is a deposit account that earns interest. After you open the account and deposit some money, the bank will pay you a percentage of the balance, called a rate, for keeping your money in the account.
What is the point of a savings account?
People open savings accounts for many different reasons. Avoiding the temptation to spend your savings, saving up for a large purchase and building an emergency fund are three common ones.
Is it worth putting money in a savings account?
For most people, yes. For one thing, it helps you with major financial goals, such as buying a car, paying for education and buying a house. And because banks pay interest on savings account balances, it's an easy way to earn free money.
Explore More on Savings Accounts
Daria Uhlig and Jami Farkas contributed to the reporting for this article.
Rates are subject to change; unless otherwise noted, rates are updated periodically. All other information on accounts is accurate as of April 22, 2024.
This article originally appeared on GOBankingRates.com: What Is a Savings Account and How Does It Work?
