Savings accounts are one of the most popular types of bank accounts, yet many people can't answer this simple question: How does a savings account work? For the most part, they're pretty straightforward. You put money in, your bank pays you interest, and you can take money back out again when you need to.
But if you want to get the most out of your savings account, it helps to have a more detailed understanding of how savings accounts work. Here's a brief overview.
If you know anything about how savings accounts work, you probably know they're designed to hold onto the extra cash you don't need right now. Banks use your funds to provide loans for other customers, and they encourage you to keep your money at the bank by offering you interest on your balance.
Because they rely on having a steady source of funds to operate, banks limit you to six "convenient" withdrawals per month from a savings account (per Regulation D). A convenient withdrawal is any method that doesn't require you to hop in your car or get on the phone. The government has waived this rule during the pandemic, so for now, you may withdraw money as often as you'd like, but this won't last forever. Your deposits are always unlimited.
Savings accounts enable you to move money around via electronic transfer and wire transfer. You can also visit a bank branch to deposit, transfer, or withdraw funds. Some savings accounts may also let you withdraw cash using an ATM card or through writing checks, but this is rare. Often, you need to transfer the money to a checking account in order to withdraw cash or write a check.
If you know how savings accounts work, you pretty much understand online savings accounts, too. The main difference is that online banks don't have physical locations, so you cannot access your funds in-person. Instead, you use online tools like apps or websites for your banking needs. The upside is that online financial institutions can afford to offer you higher interest rates than brick-and-mortar banks because they don't have to divert funds into maintaining branches.
Online savings accounts also tend to have fewer fees than traditional savings accounts, and they usually don't have minimum balance requirements. If you're trying to avoid a monthly fee or minimum balance requirement, opening a savings account at an online bank is a great way to start.
One of the biggest points of confusion about how savings accounts work is how banks calculate interest on a savings account. Every account has an annual percentage yield (APY). Most people think this is the same thing as an interest rate, but APY is actually slightly different.
APY tells you how much your balance should increase after one year. If you have a 1% APY, that means your $1,000 balance will be worth $1,010 at the end of the year, assuming you don't deposit or withdraw any additional funds. The calculation gets more complicated if your balance changes over time or if your bank changes its APY, which it can do whenever it wants.
Savings account interest usually compounds daily. So your daily interest rate would be your APY divided by 365. On the first day, you only earn interest on your initial balance. But the second day, you earn interest on your initial deposit plus the interest you've earned so far. Compound interest helps your savings grow more quickly. Your bank usually deposits any interest you've earned into your account once per month.
A common concern people have when learning about how savings accounts work is whether they're safe. If you're familiar with banking terminology, you might ask, "Are savings accounts FDIC insured?" The answer to both is yes.
Federal Deposit Insurance Corporation (FDIC) insurance is an essential part of keeping your savings account safe. It protects you up to $250,000 per person per account per bank in case of bank failure. All reputable banks have FDIC insurance on their deposit accounts, including savings accounts.
Banks also use advanced encryption on your online accounts to ensure that identity thieves don't gain access to your financial information. Of course, the safety of your savings account information depends on you as well. Take care not to leave your passwords or bank account information where someone could find them, or they may be able to access your funds remotely.
If you have extra cash you don't plan to use immediately, a savings account can be a good place for it. If you're working toward a savings goal, keeping your funds in a personal savings account can help you track your progress.
Now that you understand how savings accounts work, you can find the right one for you. Focus on choosing an account that is FDIC-insured, charges few fees, and has a high APY so you can earn the most interest on your money.
We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team. The Motley Fool has a Disclosure Policy. The Author and/or The Motley Fool may have an interest in companies mentioned.
The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.
Copyright © 2018 - 2021 The Ascent. All rights reserved.