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How Do Savings Accounts Work?
Savings gives people peace of mind.
When we don’t have any savings, a small financial hiccup can be a huge setback and potentially have long-term consequences.
“If you’re living on a tight budget and don’t have an emergency savings account, [and] if a large unexpected expense comes up,” says Taylor Jessee, director of financial planning at Taylor Hoffman, “you might not have any other option to pay the bill except to take out a loan or put it on a credit card, which can end up costing you more over the long run.”
According to a June 2020 survey, nearly half of credit-challenged Americans have experienced a budget-breaking event since early 2019, and 18% of respondents had overdrawn their accounts since the onset of the coronavirus pandemic.
While nothing in life is foolproof, building up a savings account can come in handy when those unanticipated emergencies pop up and surprise us. Below is a basic breakdown of savings accounts, how they work, and considerations for opening one.
How are savings accounts different from checking accounts?
Similar to basic checking accounts, savings accounts can be housed at financial institutions such as banks, credit unions, and online banks. They’re generally easy to open, and don’t require any special financial acumen or a large deposit.
Savings accounts aren’t meant for daily transactions like checking accounts. With a regular savings account, you won’t have the same type of privileges that come with a checking account.
“Checking accounts are really meant to facilitate transactions whereas savings are intended for accumulating interest,” says Stuart Heckman, associate professor of personal finance at Kansas State University. “Savings accounts lack many of the transaction mechanisms such as check writing and debit cards that are standard in checking accounts.”
Typically, banks try to limit the number of times you can take money out of your savings account. You may be charged a fee if you withdraw more than a set number of times imposed by the bank.
“It’s expected you’ll take withdrawals from a saving account less than a checking account,” says Vickie Hampton, Ph.D., chairperson of the department of personal financial planning at Texas Tech University.
Previously, the Federal Deposit Insurance Corporation (FDIC) had set limits on the number of savings account withdrawals or transfers that could be made each month. While COVID-related events have put a pause on those regulations, banks may still have their own policy to limit transactions with these accounts.
How do savings accounts earn interest?
Savings accounts earn interest; it may be minimal, but it’s better than a checking account, which typically doesn’t earn any interest. Interest rates will vary from brick-and-mortar banks and online banks.
“You may be able to find higher interest rates at an online bank if you’re comfortable with it, but some people prefer to visit a traditional bank,” Hampton says.
When you leave money in the savings account, an annual percentage yield (APY) is earned on that money. Savings accounts can earn interest daily, monthly, semi-annually, or annually.
Over time, compound interest starts happening. With compound interest, you’ll earn interest on the money you put into the account as well as on the interest the account accrues.
If you put an initial deposit of $100 in your savings account and commit to a monthly contribution of $50 with a .10% rate of return, after five years, your savings account’s future balance would be $3,109 and you would have accrued $22 in interest.
Considerations for choosing a savings account
There are many different types of savings accounts, from online savings accounts to high-yield savings accounts and money market accounts. After deciding which type of account to open, confirm the bank is FDIC-insured.
Reputable banks and credit unions are insured. If the bank goes out of business, the federal government will guarantee that you’ll be able to get your money back. The FDIC insures up to $250,000 per person per bank.
There are a few other factors to keep in mind when deciding on where to house a savings account:
When looking at savings accounts, you’ll want something that’s doable for your financial goals and how you prefer to bank. It’s important to know how easy or difficult it will be to withdraw money out of the account if you have an emergency, as well as how seamless an automatic transfer from your checking account can occur.
Depending on the bank, they may have limits on how often you can take out funds. Other banks may not have a monthly limit but could charge you a fee for going over a certain number of withdrawals.
Other monthly fees
Most banks don’t charge a monthly maintenance fee for a savings account, but some do. Some bank accounts may also require you to maintain a minimum balance in your savings account. Check the terms to determine if there are any requirements for the account.
If your rainy-day fund is in the same place as your checking account, you may be tempted to spend it. For this reason, having a savings account that does not connect to your checking account can protect your savings from non-emergency spending.
“Having a dedicated account helps consumers from a behavioral perspective by keeping the money separate and perhaps less accessible,” Heckman says.
Type of account
A traditional savings account also protects your money from market fluctuations. When an unanticipated expense does arise, savings accounts give you easy access to your money.
“It’s important to have liquid savings to pay for things in the short-term, Hampton says. “You don’t want that money in anything that is going to fluctuate market-wise.”
New to saving? 3 steps for beginners
Make your savings account work for your personal situation. Here are three steps for getting started.
Step No. 1: Start with a spending plan
Figure out how much you can save regularly or start with a small savings goal. Even $20 a month can make a difference when you have an emergency expense. If you can, plan to increase the amount of money you save regularly to help ease future financial burdens.
Step No. 2: Set up a savings account with an automatic transfer
As a starter saver, it may be easiest to set up a savings account at the same bank that holds your checking account. If you’re transferring money from a checking account to a savings account at the same bank, it’s unlikely there will be any fees.
Every month or pay period, designate a specific amount to transfer from your checking account into your savings account.
“Setting up an automatic transaction from checking to savings can help build your savings habit,” Hampton says.
Step No. 3: Save up enough for an emergency fund
Most financial professionals advise saving about 3-6 months of living expenses for emergencies. This money is also for tapping when an unexpected cost pops up, such as a car or home repair, and can go towards funding your financial goals.
Vickie Hampton, Ph.D., is Chairperson of the Department of Personal Financial Planning at Texas Tech University. She received her Master of Science and Ph.D. degrees in Family and Consumption Economics at the University of Illinois - Urbana. Before coming to Texas Tech, Hampton taught and conducted research in personal financial planning at the University of Texas - Austin.
Stuart J. Heckman is a certified financial planner and an associate professor of personal financial planning at Kansas State University. He currently serves as the academic editor for the Journal of Financial Planning. His research focuses on professional financial planning and on financial decisions involving uncertainty, especially among young adults and college students.
Taylor Jessee is a CPA and Certified Financial Planner professional. He is the director of financial planning for Taylor Hoffman, a wealth & capital management firm based in Richmond, VA.