Published in: Banks | Dec. 10, 2018
How Does a Savings Account Work?
Learn the ins and outs to decide if it’s the right account type for you.
There are two main types of deposit accounts offered by banks to customers -- savings and checking. Savings accounts are designed as vehicles to build money over time, while checking accounts are intended as pass-through financial accounts for customers to temporarily store money that will be used to pay bills and other day-to-day expenses.
With that in mind, here’s a rundown of how savings accounts work, how interest is calculated, and whether a savings or checking account could be the best choice for you.
The short answer
In simple terms, a savings account allows the account owner to keep their money in a safe place (a bank), while also allowing them to earn interest on their balance.
We’ll discuss savings account interest in the next section, but as far as the “safe place” part of the definition goes, banks not only have excellent security, but money in U.S. savings accounts is insured by the Federal Deposit Insurance Corporation (FDIC) up to a maximum of $250,000 per account holder, per bank. In other words, if you have $10,000 in a savings account, and your bank loses all of its money and goes out of business, the FDIC will be sure you get your money.
Savings accounts often have minimum balance requirements, and there’s often a maximum number of transactions -- particularly withdrawals -- that can be made each month from a savings account without incurring a fee. Unlike checking accounts, savings accounts are not designed mainly as pass-through accounts. Instead, the general point of a savings account is to gradually accumulate a higher balance over time.
Savings account interest
The main reason banks offer savings accounts is to fund loans for other customers. As a simplified example, if a bank takes in $1 million in customer deposits, it can then loan that money out to other customers -- for mortgages, auto loans, and other types -- and can charge those other customers interest.
Therefore, to entice people to keep their money in the bank, savings accounts pay interest to the account holder. This is compounded over short time intervals, with most banks choosing to compound interest daily. In other words, if a bank’s savings account interest rate is 1%, you don’t simply get 1% of your balance at the end of the year. Instead, your interest rate is divided by 365 and is added to your account balance daily.
In a nutshell, compound interest means that interest is applied on your balance and any interest you’ve accrued. For example, if you have $10,000 in a savings account and receive $1 in interest for today, tomorrow’s interest payment will be calculated based on $10,001.
To be clear, savings account interest generally posts to the account on a monthly basis. However, in most cases, it is compounded daily.
Traditional vs. online savings
In today’s banking landscape, savers have the choice between traditional savings accounts at brick-and-mortar banking institutions or online savings accounts. Each option has its pros and cons.
The main argument in favor of traditional savings accounts is the convenience factor. With a savings account at a physical bank, you can simply drive to a branch and deposit money, either in person or at the bank’s ATM. Many physical banks have widespread branch and ATM networks, and savers often value this convenience. For example, it’s easy to deposit $100 in cash into a traditional savings account. With an online savings account -- not so much.
On the other hand, online savings accounts generally pay much more interest than traditional savings accounts do. As of this writing, the national average savings account APR is 0.08%, but online savings accounts with APYs (annual percentage yields) of 1.85% or more are readily available. And if you’re willing to leave your money alone for an extended period of time, online CD rates of up to 3% are available. Plus, many online savings accounts offer some degree of ATM fee reimbursement, so it can be easier than you think to withdraw cash.
Should you get a checking or savings account?
As I mentioned, savings accounts are designed primarily for deposit transactions. If your goal is to consistently build your balance over time and to access your money only on rare occasions, a savings account could be right for you. For example, a savings account can be the right tool if you’re trying to accumulate an emergency fund to help deal with unforeseen expenses.
On the other hand, if you plan on regularly depositing and withdrawing money from your account -- using the money to pay your bills, for example -- a checking account may be the better choice. Savings accounts generally charge account owners for frequent withdrawals, and as a personal example, my bank allows six withdrawals per month before a fee kicks in.
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