Savings Account 101: How does a Savings Account Work?

A savings account is one of the most basic and essential financial products that everyone should have. But how exactly does a savings account work? What are the benefits of having one? This comprehensive guide will explain everything you need to know about opening, using and maximizing a basic savings account for you to earn the most money.

What is a Savings Account?

A savings account is a type of bank deposit account that allows you to earn interest on the money you deposit. It provides a safe place to build your savings separate from your everyday spending account.

Savings accounts are offered by banks, credit unions, online banks and even some investment brokerages. They provide consumers with an accessible place to park cash and watch it grow via compound interest over time.

The main allure of savings accounts is that they offer higher interest rates than regular checking accounts, while still allowing easy access to your money when needed. Although rates are still relatively low compared to other investments, a savings account provides a hands-off way to earn passive income as your balance grows.

How Do Savings Accounts Work?

Opening and using a basic savings account is straightforward:

• Open the account. You can open a savings account at a bank branch or digitally in a few minutes by providing personal information and making an initial deposit.
• Make deposits. You can add funds to your account via cash or check at a branch, electronic transfer, direct deposit, mobile check deposit, ATM, etc.
• Earn interest. The bank will pay interest on your account balance. The interest compounds according to the account’s rules.
• Access funds. You can withdraw money in-person, at ATMs, by transfer to a linked checking account, or via online/mobile banking.
• Pay taxes. The interest earned is considered taxable income. You’ll receive a 1099-INT form to report savings account interest on your tax return.

Below are some key factors that affect how interest accrues on your deposits:

• Interest rate (APY) – This is the annual percentage yield earned on your account. The higher the APY, the more interest you’ll earn.
• Compounding frequency – This is how often the accrued interest is added to your balance. It’s typically daily, monthly or quarterly. More frequent compounding will help your balance grow faster.
• Account balance – The more money you have deposited, the more interest you’ll earn (assuming a fixed APY). Even small balances can grow noticeably with compound interest over time.
• Time – The longer you leave money in the account untouched, the more compound interest can work its magic. Time is one of the biggest factors in growing savings via compounding.

Benefits of Savings Accounts

There are many good reasons to open and regularly use a basic savings account:

• It’s risk-free – Up to $250,000 per depositor is insured by the FDIC at banks and NCUA at credit unions. Your money is very safe.
• Earn passive interest – You earn interest just for saving your money in the account. It takes zero effort after your initial deposits.
• Liquid access – You can easily withdraw funds anytime without penalty, unlike CDs which charge early withdrawal fees.
• Convenient access – Check your balance, make deposits and withdrawals digitally 24/7 via online/mobile banking.
• Short-term savings – A great place to save for near-term goals like an emergency fund, vacation, vehicle, home repairs, etc.
• Separate from spending – Keeping savings and spending money separate helps avoid dips into savings for non-essential purchases.
• Grow your wealth – Consistently saving even small amounts can gradually grow your net worth as interest compounding works its magic over months and years.

Types of Savings Accounts

While the basic mechanics are similar across institutions, you can find savings accounts with varying features, rates and rules depending on the provider. Below are some common savings account types:

• Standard savings – Offered at brick-and-mortar banks and credit unions. Tend to have lower interest rates and may charge monthly fees.
• High-yield savings – Offer above-average rates, often from online banks with lower overhead costs. Some have minimum balance requirements to earn the highest yields.
• Money market accounts – Earn interest with check writing and debit card convenience. Limited to 6 withdrawals/transfers per month by federal regulation.
• Kids & student savings – Accounts for those under 18/21. Help teach savings habits but offer lower rates than standard savings accounts.
• Specialized savings – Some banks have accounts for certain goals like Christmas shopping, vacations or home down payments. These sometimes limit access to funds until a specific time.

Opening a Savings Account

Ready to open your first or next savings account? Here is a step-by-step guide:

1. Shop around – Compare interest rates, fees, minimum balance rules and other features across banks and credit unions. Include online banks in your search for the best APY.
2. Choose an institution – Select the savings account that offers the ideal blend of high APY, low fees and convenient access for your needs.
3. Apply online or in-person – You can open most savings accounts digitally in minutes or visit a local branch. Have your ID and Social Security number ready.
4. Make your initial deposit – Fund your new account from another bank account via electronic transfer or deposit a check. Some banks require a minimum opening deposit.
5. Set up digital access – Sign up for online and mobile banking to easily manage your account from anywhere 24/7.
6. Automate deposits – Set up recurring transfers from your checking account so you effortlessly build your savings over time. Even small auto-deposits add up.
7. Watch your savings grow – Let the power of compounding interest work for you. With regular deposits, your balance can grow surprisingly fast.

How Much Should You Save?

As a general rule, aim to save at least 10-20% of your take-home pay if possible. Beyond that, how much you save depends on your financial goals:

• Emergency fund – Have 3-6 months’ worth of living expenses saved for unexpected costs. 6-12 months’ worth provides an extra cushion.
• Short-term goal – Save enough to fully fund goals like vacations, vehicles, home renovations, etc. Use a savings calculator to determine the required amount.
• Major purchase – Buying a home? You’ll need to save up at least 3.5-20% of the purchase price for a down payment, plus closing costs.
• Retirement – For retirement, aim to save at least 10-15% of your income over your working years including any employer contributions.

Maximizing Your Savings Account Earnings

While savings account interest rates remain relatively low compared to other investments, you can maximize your earnings with these tips:

• Open accounts at online banks or credit unions to earn higher yields.
• Shop around for the top rates and switch banks when you find a better deal.
• Take advantage of signup bonuses that offer $100-$200+ for new customers.
• Avoid accounts with monthly fees that eat into your interest earned.
• Reduce withdrawals so more interest can compound. But keep some liquidity for emergencies.
• Use a compound interest calculator to quantify savings growth over time.
• Use multiple accounts to keep different savings goals separated and maximize FDIC insurance.

Alternatives to Savings Accounts

While savings accounts should be part of your financial toolkit, they aren’t your only option. Here are a few other places you can stash cash:

• CDs – Certificate of deposits pay higher interest for locking up your money for a set period of time, ranging from a few months to 5 years. Early withdrawal penalties apply.
• Money market accounts – These give you debit card and check writing access while paying interest. Check the transaction limits and minimum balance rules.
• High-yield checking – Some checking accounts pay decent interest with debit card and check access. You sacrifice a bit of interest vs. a dedicated savings account.
• Cash management accounts – Brokerages like Fidelity and Schwab offer FDIC-insured accounts to hold cash earning interest while investing elsewhere.

FAQs

What guarantees the safety of my savings account?

Savings accounts are insured by either the FDIC at banks or the NCUA at credit unions. This federal insurance protects your deposit up to $250,000 per account ownership category in the event the institution fails. So you cannot lose your principal savings as long as you remain under the coverage limits.

Can I lose money in a savings account?

You cannot lose the principal amount you’ve deposited into a savings account. However, the purchasing power of your savings can be eroded over time by inflation if your account’s interest rate does not keep pace with the inflation rate. Choosing an account with a competitive rate can help minimize purchasing power loss.

What interest rate can I expect from a savings account?

Savings account annual percentage yields (APYs) can vary greatly. The national average is around 0.06%, while the highest rates from online banks reach over 4%. Brick-and-mortar banks typically pay 0.01% – 0.05% APY. Online banks tend to offer the highest yields since they have less overhead.

How does compound interest benefit my savings account?

Your interest compounds based on the account’s rules – typically daily, monthly or quarterly. Compounding pays interest on both your deposited principal and previously earned interest. This snowball effect results in your balance growing faster over time compared to simple interest. Frequent compounding (daily or monthly) maximizes the benefits.

What are the typical fees for savings accounts?

Common fees include monthly maintenance fees, usually around $4-15 unless waived by maintaining a minimum balance. You may also incur fees for withdrawing money more than six times per month, requesting paper statements, or having an inactive account. Choose a bank that offers a savings account with minimal fees.