Banks run on other people’s money. In simplest terms, Joe deposits $50,000 into his savings account, entrusting it into the bank’s care. His bank uses that money to give Mary a $25,000 personal loan. The bank is literally borrowing from Joe so Mary can borrow from them. Meanwhile, Mary is paying interest on her loan, and the rate is significantly higher than the interest that the bank is paying Joe on his savings account deposit. That’s profit for the bank – it made money on these two folks.
Banks move money around to make money. It’s all perfectly legal and the money is safe. Joe’s bank’s deposits are insured up to $250,000 by the Federal Deposit Insurance Corporation or FDIC, so there’s no way Joe can lose that $50,000 if his bank makes bad lending decisions and it goes out of business.
This whole system begins when money is placed with banks in deposit accounts like savings accounts. But what’s in it for the consumer?
The Purpose of Savings Accounts
Financial gurus say that everyone should have some money stashed aside in an emergency fund in case life throws a curveball. An amount equal to three to six months' living expenses is usually recommended, but some experts say that you should have the equivalent of “at least” six months' of bills tucked away. It’s security in the event that you lose your job, suffer a serious illness or if some other calamity occurs that prevents you from working. The money can come in handy if your furnace blows up as well.
And you don’t necessarily have to save for a doomsday situation, or at least you don’t have to save only for that. You might open a savings account to segregate money you want to spend on your wedding, a dream vacation or a down payment on a new home. Your bank is more than glad to hold onto that money for you, and you can take it back effortlessly when and if you want it. The arrangement makes both you and your bank happy. Your money is safe, and your bank can keep doing business.
Maybe you already have a checking account, so you don’t see the sense of opening a separate account for savings. You can just let your money keep building up in your checking account, right? That’s not recommended for a couple of reasons. It’s easier to dip into a checking account and spend that money when it’s not segregated, and savings accounts pay a slightly higher interest rate than checking accounts do.
Accessibility: When You Want Your Money
You won’t have to move mountains to get to your money when you want or need it if you put it in a savings account, but you might be limited as to how often you can do so. Federal law has historically limited consumers to no more than six withdrawals a month or in a statement cycle, and this includes transfers out of your savings account to another account, such as checking.
But here’s a bit of good news during the 2020 coronavirus pandemic. Uncle Sam knows that people are struggling right now, so this six-withdrawal rule has been lifted, at least temporarily and possibly permanently. You might not have to deal with this going forward but, unfortunately, banks aren’t legally required to follow this mandate. They can still impose this limit if they want to and some will probably want to because they can charge a financial penalty for going over the limit.
You can set up automatic transfers from your checking account to savings with most banks, so you won’t have to remember to make transfers to savings from your checking account or worry about being disciplined enough to save some of that paycheck. And, of course, transfers don’t have to be automatic. You can make them yourself whenever you like without making a trip to the bank. Almost all reputable institutions offer online banking and mobile apps, and these transfers usually happen immediately.
Interest: Your Money Earns Money
Now, about that interest the bank will pay you in exchange for letting them hold your money for you. Don’t get too excited. It’s not much, averaging about a 0.04 to 1 percent annual percentage yield, commonly referred to as API. This is a calculation based on the interest rate and how often it’s compounded.
Online banks tend to pay higher interest rates than banks with physical locations. Remember, banks are using deposits to fund their operations, and online banks have less in the way of overhead so they don’t need quite as much income. Credit unions typically pay better, too, because they’re member-based. Their services aren’t available to the public at large.
The interest rate your savings account earns isn’t carved in stone. It can change on a dime. It might be a smidgen more or less tomorrow than it is today based on the economy and other factors.
Savings account interest compounds. This means that if you earn a dollar in interest today and that’s added to the $100 you had saved, your next interest payment will be based on a balance of $101. Savings account interest can compound daily, monthly or even just once a year, depending on the bank.
Earning interest isn’t automatic when you put your money into a savings account. Some – but not all – banks require that you maintain a minimum balance in exchange. Interest won’t be paid on balances that are less than this amount, but the limits typically aren't prohibitive. Here’s what you can expect with regard to interest rates and minimum deposits at some better-known banks as of 2020:
- Sallie Mae Bank (online): 0.85% with no minimum balance
- Capital One and Discover (both online): 0.80% with no minimum balance
- American Express Personal Savings (online): 0.80% API on balances over $1
- Bank of America, Chase Bank, Citizens Bank, Commerce Bank, KeyBank and Wells Fargo Bank: 0.01% with no minimum balance requirements
- TD Bank: 0.01% on balances over $0.01
Not All Savings Accounts Are Created Equal
There are savings accounts, and then there are savings “products.” The interest rates cited above all apply to standard, run-of-the-mill savings accounts, but you have some fancier options available to you and they pay more.
High-yield savings accounts tend to be more generous than others when it comes to interest rates, and they’re often offered by online banks.
Money market accounts are a step above savings accounts, and they can serve double-duty in some respects by also acting like checking accounts. Depending on the bank, you can write checks on the money you hold there, and you might even get a debit card. Of course, this can undo the idea of saving if you can get to the money that easily, and these accounts typically have much higher minimum balance requirements in exchange for paying higher interest rates.
Certificates of deposit are designed for more long-term savings goals, such as your child’s college education. You would commit to leaving your money with the bank for a certain period of time, making no withdrawals during this time, but you’ll receive a much better interest rate because the bank knows it can count on your money staying put for a while. Rates go up the longer you agree to leave your money on deposit. You’d typically lose all interest earned and maybe even some of your initial deposit if you withdraw early.
Read More: Certificate of Deposit Pros and Cons
Savings Accounts Have a Few Drawbacks
One thing to keep in mind is that fees and costs can nibble away at that paltry interest you’re earning on a standard savings account. There might be financial penalties for failing to keep a minimum balance, as well as transaction fees and maintenance fees. Again, online banks have an edge here because they’re less likely to impose minimum balances.
It’s not unheard of for a bank to wave a seriously nice interest rate at you to get you to sign up for an account, only to cut that rate to the bone a few months later. These are “introductory” interest rates, not intended for the long term, so ask about this when you’re opening an account.
How to Open a Savings Account
Opening a savings account requires minimal effort if you think these advantages sound pretty good to you and you can live with the drawbacks. You’ll need some cash to put into the bank account to get started, of course, and some banks require that your initial deposit be at least a certain amount. But many banks will let you get started with just a small deposit.
You’ll want to compare interest rates, maintenance fees and any minimum account balance requirements when you're selecting a bank, and check to be sure you’re eligible for a savings account if you’re considering a credit union. Remember, these are membership organizations, so you must meet the criteria for becoming a member. They’re very similar to banks in the services they provide, but they’re not quite the same.
And here’s something to keep an eye out for when you’re shopping around for the best bank: Some will even offer you a sign-up bonus. You’d open a savings account with your initial deposit, then the bank will drop a few hundred dollars or so into your account on top of that.
You’ll need identification – proof that you are who you say you are – whether you’re thinking of going with an online bank or you’d prefer that your bank have the solidity of a big, brick building. Some brick-and-mortar banks will require that you turn up there in person to open a savings account, but a few can actually require that you do it online, even though their location is within walking distance. Ask about the process when you’re comparing banks.
And be prepared for a credit check, even though you’re giving the bank your money rather than asking to borrow it. The banking institution might want to know that you’re responsible with handling money. This could be an issue if you’ve struggled financially in the past, and the credit check can affect your credit score if the bank does a hard inquiry rather than a soft one. A hard inquiry can drop your credit score by up to 10 points and it will stay on your credit report for as long as two years.
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Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.