What is a Savings Account? How They Work

What is a savings account?

A savings account is an interest-bearing account where you can deposit money and earn returns based on your balance.

The addition of interest helps separate these accounts from checking accounts, and you also won’t have as much freedom in terms of how often you withdraw money from an ATM or the bank. That’s because the cash you sock away for savings should sit there — how long it sits there and how much interest you ultimately accrue depends on your preferences and the type of account you choose.

How does a savings account work?

When you open an account intended for savings, you’ll be asked to make an initial deposit that meets the financial institution’s required minimum.

You’ll also fill out some forms, either in person or digitally, and perhaps share copies of your government-issued identification (a driver’s license is probably fine).

How interest makes your savings account work for you

Your savings account works by generating interest according to your annual percentage yield or APY. Typically, traditional accounts have the lowest rate of return, while high-yield savings accounts deliver the best rates.

Another detail to explore is how your bank compounds interest. Some compound interest daily or monthly, while others compound interest quarterly or annually. This is important to know because shorter compounding periods mean more money for you.

Say you have $5,000 to put into savings. All account options offer the same APY of 2%, but they have different compounding periods. If you made zero additional deposits, here’s how each account looks after a year:

• Daily compounding: $5,101
• Monthly compounding: $5,100.92
• Quarterly compounding: $5,100.75
• Annual compounding: $5,100

Funding and making deposits to your savings account

You have several easy access options to make your initial deposit and add funds over time:

• ATMs, using a debit card
• In-person via a bank teller
• Mobile check deposit (typically requires a linked mobile app)
• ACH transfers through a linked checking account
• Wire transfers
• Direct deposit

Before you open your account, be sure you know how often you can make transactions. Some accounts have fairly flexible terms. Other accounts are more restricted, with many banks sticking to the COVID-19 era six-per-month transaction limit. For specialty savings accounts like an IRA, you may not be able to withdraw money until retirement age without facing significant penalties.

Benefits and drawbacks of savings accounts

Before you sign on the dotted line for your new account, get to know some pros and cons of bank-backed savings vs. your standard checking account.

Benefits of having a savings account

Savings account pros include:

• Having money in savings ensures you have some financial backup, like a rainy-day fund.
• You may be able to link your savings and checking accounts for extra overdraft protection and to make quick withdrawals via ATM.
• Deposit accounts — especially high-yield savings — can help you grow your money with very little risk or effort.
• Partnering with a third-party U.S. bank means you have Federal Deposit Insurance Corporation (FDIC) coverage of up to $250,000 per depositor, per institution — if the bank folds, you still get your money back.

Drawbacks to having a savings account

Some cons of savings accounts include:

• You may not be able to withdraw money from an ATM or bank without incurring penalties, making it difficult to tap into your emergency fund as needed.
• Online banks may offer better APY, but the lack of in-person locations could make it harder to interact with the customer service team.
• Variable APY could make it challenging to grow your money as expected.
• You must maintain a minimum balance or face higher fees and, in some cases, lower interest rates.

Types of savings accounts

There are multiple types of accounts you can use for your savings.

Depending on your savings goals, how much you planned to initially deposit, and your willingness to let the money sit untouched, it’s likely some account types will be a much better fit for you than others.

These are the main types of savings accounts available:

Get to know some of the following savings accounts:

How to open a savings account

Opening your bank account is a simple four-step process.

1. Choose the financial institution and type of account you prefer.
2. Fill out the required paperwork to open a savings account and present government-issued identification as required by your bank or credit union.
3. Make your minimum deposit.
4. Watch your money grow and try to maintain that minimum balance to avoid high monthly maintenance fees.

Does opening a savings account affect your credit?

Opening and maintaining a savings-focused account will not affect your credit score.

Some institutions will run a soft credit check to verify the identity of the account holder, but this will not impact your score.

How to maximize earnings from a savings account

Here’s how you can make the most out of your savings:

• Pick the account that’s best for your needs. It’s no use going with an account that has a higher interest rate if you’re going to lose money for exceeding withdrawal limits.
• Monitor your rates. You can always switch banks if yours no longer offers the best APY.
• Consider diversifying. Splitting up your savings across multiple FDIC-covered accounts could offer extra protection.
• Automate your deposits. One way to grow your savings is to set up automatic transfers from checking to savings every payday.

How much should I keep in my savings account?

How much should I have in savings? If your primary goal is to create an emergency fund, you should save money equal to 3-6 months’ worth of expenses. Otherwise, transfer enough money to grow the account, but not so much that you can’t cover short-term living expenses.

Can I lose money with a savings account?

The only way you can lose money with a savings account is if you acquire more fees than your interest can cover. For instance, making too many withdrawals or not meeting minimum balance requirements could result in higher monthly maintenance fees or other penalties.

Alternatives to savings accounts

These savings account alternatives can also help you protect your money and save for the future.

• Certificates of deposit (CDs): CDs offer a decent and fixed rate of return and are insured by the FDIC, but your money is locked up long-term until the end of the agreed-upon period (often 1, 3 or 5 years).
• Cash management accounts (CMAs): A CMA is checking, savings and investments rolled into one account. Most of these accounts are offered by virtual institutions rather than banks, but deposits may still be protected through partnerships with FDIC-insured banks.
• High-yield checking: This type of checking account offers low interest rates alongside unlimited deposits and withdrawals.