Saving your money in a savings account is the easiest way to set yourself up for financial success. When you save your money, it opens doors for you to invest, buy a home, go on vacation, and more.
Although most banks offer free savings accounts when you open a checking account, you may not know what they are and why you should use them. Perhaps you just leave all your money in your checking account and ignore your savings account.
Today, you’ll learn everything you need to know about savings accounts, what they are, why you should use them, and more. Let’s dive in.
Savings accounts for beginners
What is a savings account?
A savings account is a type of bank account that lets you store your money and earn interest. You can find savings accounts at both banks and credit unions. They are a safe place to house your money because they have deposit insurance for up to $250,000, provided by the FDIC and NCUA.
You can usually open a savings account with little or no money at most online or physical banks. You can even find savings accounts at some brokerage firms, where your investing account and retirement account are usually held.
How do savings accounts work?
In an oversimplified way (without getting into reserve requirements), the money you store in a savings account is the money your bank uses to make loans. In the eyes of your bank, a dollar saved is a dollar lent. Without your money, the bank cannot make loans, which means they cannot make money.
For this reason, banks are willing to offer you interest on the money you put in your savings account. Some banks will even go as far as to offer high-yield savings accounts, which are known to offer 20x more than traditional savings accounts.
On the contrary, traditional savings accounts (such as the one you probably have at your local bank) will usually offer an annual percentage yield between 0.01% and 0.06%. So while your bank is technically giving you money, they are also using your money to provide mortgage loans, student loans, credit cards, and more.
The interest they are charging on those loans can range from 4% APR to 18% APR, a substantial percentage markup from what they are giving you for your savings.
Why you need a savings account
Although we always recommend investing your money over saving it long-term, there are a few legitimate reasons why you would want to use a savings account, such as:
- Emergency fund: If you don’t already have an emergency fund, now would be a great time to start one. An emergency fund is a safety net that protects you from surprise expenses. We recommend you have at least three months’ worth of expenses in your emergency fund. This should be enough to cover most emergencies, including unemployment. Keeping your emergency fund in a separate savings account is a great way to keep it safe and away from the temptation to draw from it for everyday expenses.
- Big purchase: If you are saving up for a big purchase in the near future, such as a down payment on a home or car, a savings account is the place to store it. We’d recommend keeping the money for big purchases in a high-yield savings account to maximize the earning potential for your savings.
- Save to invest: We don’t recommend you ever save money just for the sake of saving. Money is a tool, and you should always put it to work. If you are saving your money to invest it, then using a savings account makes sense. Perhaps you are saving up to purchase your first rental property or for a new business. Whatever the case, you are making a smart decision to invest, and temporarily housing your money in a savings account is ideal.
- Safety: Your money should not be going under a mattress or in a shoebox in your closet. Savings accounts are insured up to $250,000 by the federal government, making them a safe place to hold your money. And, unlike holding your cash physically, the money in your savings account is collecting interest and growing over time.
Are online savings accounts safe?
If you have never used an online savings account, you may be skeptical about their safety and legitimacy. However, most online savings accounts are FDIC insured up to $250,000, like savings accounts at physical banks.
In fact, many big banks like Citi and Goldman Sachs offer online savings account options. These savings accounts tend to offer above-average interest rates when compared to traditional savings accounts. Because the account is online, the bank doesn’t have to pay for bank tellers and administrators—they can pass those savings along to you in the form of higher interest.
There are also many newer online-only banking options available, such as Ally and Synchrony. These banks do not have any physical locations to prevent extra overhead costs. Instead, they focus on winning you over by giving you better rates on loans, savings accounts, and more.
How much should you keep in your savings account?
How much you keep in your savings account strictly depends on your financial goals and objectives. For example, if you are building an emergency fund, you will likely have more in your savings account than if you were only using the account for loose funds.
If you are using your savings account to store your emergency fund, most financial advisors recommend keeping a minimum of three months’ worth of living expenses. In other words, if your family needs at least $2,500 per month to survive, you would want to keep $7,500 in your savings account.
However, maybe your goal isn’t to save for an emergency fund. Perhaps you are saving for a vacation or a down payment on a new home. In these situations, the amount of money you keep in your savings would be based on those specific goals.
We typically recommend you open a high-yield savings account outside of your home bank for most saving goals. This makes the money more inconvenient to access, which helps prevent you from withdrawing from the account for unrelated expenses.
Advantages of savings accounts
- Liquidity: When you put your money into a savings account, you have access to it whenever you want. And when you do access it, you’ll get back exactly what you put in (aside from what you’ve lost due to inflation).
- Earn interest: Unlike most checking accounts, savings accounts will pay you interest on your savings. For that reason alone, putting your money into a savings account is a better alternative than putting it in the sock drawer.
- Federally insured: Savings accounts are backed by the full faith and credit of the United States government up to $250,000, which means you can never lose your money. The FDIC insures bank accounts, and the NCUA insures credit union accounts.
Disadvantages of savings accounts
- Low interest: Although savings accounts pay you interest on your savings, the interest paid is usually very low compared to other investments. For example, most traditional savings accounts only pay you between 0.01% and 0.06% in interest. High-yield savings accounts pay a little higher, between 0.7% and 2.0% or more. But when compared to investments such as stocks and ETFs, savings accounts return very little.
- Withdrawal restrictions: You are only allowed to withdraw from your savings account up to six times per month. This rule is also known as Regulation D and was put in place by the Federal Reserve. It’s worth mentioning that in early 2020, the Federal Reserve announced that it would no longer require banks to enforce the six-per-month limit. However, banks can still charge you a fee for excess withdrawals, and many do.
How to open a savings account
The first thing you’ll need to do to open a savings account is to decide on a financial institution. Depending on your goals, your choices may vary. For example, if you are looking to earn the most interest on your savings, we’d recommend going with a bank that offers high-yield savings accounts such as Ally, Synchrony, or Citi.
If you prefer to have access to your money at a physical branch location, you may want to stick with your current bank or a local credit union.
Keep in mind that many online banks and credit unions offer better interest rates on loans, lower maintenance fees, and smaller minimum balance requirements. However, if you are only saving your money and don’t plan to use any of the financial services offered, these options won’t be essential to you.
When opening a savings account, you’ll need to have several documents or pieces of information available. It’s common for banks to ask for a driver’s license or state ID, Social Security card, proof of address, date of birth, employment, and other general information.
Banks may also require you to make a small minimum deposit when you open your account. Even more, some banks will require you to open an account at a physical branch location, so if this isn’t an option, you should stick with an online bank.
Savings account alternatives
- Money market accounts: Money market accounts (MMAs) are savings accounts that offer features similar to checking accounts. For example, many money market accounts will come with a debit or ATM card and give you the ability to write checks. These are typically reserved for a checking account and cannot be done in a savings account. Money market accounts also tend to offer better interest on your savings than a traditional savings account.
- Certificate of deposit (CD): CDs are a type of time-deposit that you can open at most banks or credit unions. CDs are slightly different from savings accounts in that they aren’t as liquid. When you open a CD, your money is locked for the duration of the term. The term duration of a CD can be as short as 1-month up to 5 years. Generally, the longer the term, the more interest you earn.
Now that you know what a savings account is, you should be in a better position to use them smartly. Savings accounts are not perfect for every scenario, and you certainly shouldn’t be stashing your entire inheritance in them.
However, overall they are useful products that can provide you with peace of mind.