Many great investors have gotten rich in the stock market, but when you're first starting out, most people have their first financial experience at a local bank. No matter how much money you have, a savings account can be a smart place to stash short-term cash. The key, though, is to put the right amount of money in your savings account, with enough to cover immediate needs but not so much as to cost you in long-term investment returns. Let's take a closer look at exactly what a savings account is and the right way to use it as part of your overall financial plan.
What is a savings account?
A savings account is a bank product that pays you interest in exchange for your leaving money on deposit. You can generally add new deposits or make withdrawals at any time, with no restrictions on when you make transactions or how much money each transaction can involve.
Savings accounts are insured by the FDIC up to the maximum limit allowed by law, which is currently $250,000 per accountholder. In determining that limit on protection, though, you have to add together all the accounts that you hold at a given bank. So if you have other accounts such as CDs or checking accounts, you have to look at the total you have on deposit to make sure it doesn't go over the limit.
Unlike a checking account, a savings account doesn't give you the ability to write checks against your balance, but you can still make regular withdrawals and transfers as long as you comply with the restrictions that federal banking rules put on savings accounts. Specifically, the Federal Reserve's Regulation D puts a limit of six preauthorized withdrawals or transfers from a savings account during a monthly statement period, whereas withdrawals from checking accounts are unlimited.
It's easy to realize why you might want to have money in a savings account. By having additional money on hand, you can deal with unexpected financial emergencies without going into debt or having to take extreme measures like selling off assets. The fact that savings accounts pay interest is just an added bonus in many situations.
In addition, you want to have enough money in your account to avoid any unnecessary fees. Many banks charge monthly maintenance and other fees on savings accounts, but those who hold certain minimum balances on deposit have those fees waived. Be sure to know how much money it takes to minimize or eliminate fees and aim to have at least that much in your savings account at all times.
Why putting too much in savings account isn't smart
Yet many people save too much of their money in savings accounts, and that can be just as big a mistake as not having enough money in savings. The reason: Savings accounts tend to pay relatively little in interest, with the need for constant liquidity being of paramount importance to accountholders. For years now, it has been hard to find savings accounts that pay even 1% in annual interest to their investors.
Of course, the trade-off is that you can never lose money in a savings account as long as you stay under the FDIC limit. Yet when you think about the true value of your savings, with the rate of inflation being higher than what most savings accounts pay in interest, every dollar you put into a savings account slowly loses its purchasing power even after accounting for any income the account produces.
Because of this, a savings account shouldn't be your sole method of saving and investing for the future. Savings accounts are good for short-term needs, where you expect to use the money within the next several months. For needs that are years into the future, though, savings accounts are unnecessarily conservative for most investors and can lead you to miss out on the superior returns available from other investments.
Knowing what a savings account is a key step in getting you on the path toward financial independence. But it's only the first step, and you should continue beyond savings accounts to get brokerage accounts, mutual funds, and other financial tools that will do a better job of producing long-term growth for your net worth. Understanding the role your savings account should play is a great lesson that every beginning investor started out learning and can lead to a lifetime of smart money management.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.