What is a savings account?

Savings account definition

A traditional savings account is a type of bank account that earns interest and is intended to hold funds you access only occasionally. In this way, they sit somewhere between checking accounts and certificates of deposit (CDs).

1. Checking accounts are high activity accounts, which is why they're referred to as demand deposits. You deposit money into a checking account for the primary purpose of dispersing the money. Payments are typically made to either pay bills, spend funds using a debit card, or access cash through an ATM. This is why checking accounts come with paper checks, online bill payment capability, and debit cards.
2. Certificates of deposit are the exact opposite of checking accounts. These are technically referred to as time deposits. When you purchase one, you're required to hold it for the specified term. You cannot pay bills, write checks, or use a debit card against a CD.

Savings accounts combine some elements of both checking accounts and CDs. Like checking accounts, you do have access to your money. And like CDs, savings accounts generally pay interest.

But what most separates savings accounts from checking accounts is the number of transactions you can run through the account. Savings accounts have a specific limit on transactions. Checking accounts have no limits.

Savings accounts features

The specific details of a savings account will vary from one bank to another. But some features are typical of savings accounts, though they may differ by degree.

For example:

• A bank may or may not require a minimum initial deposit.
• Savings accounts generally pay interest.
• Some savings accounts have tiered interest rate structures, paying higher rates on more significant balances.
• Interest rates paid on savings can vary dramatically from one bank to another.
• A savings account may or may not have a monthly fee. But if there is a fee, it may be waived if you maintain a certain minimum account balance.
• A bank may or may not allow you to link a savings account to a checking account for overdraft protection.

What to look for in a savings account

Savings accounts are primarily designed to hold funds that have a specific purpose in the medium term. They're not intended to be either checking accounts or investment accounts.

When shopping for a savings account, keep in mind the following:

• Interest rates do matter. In general, a bank that pays higher interest on a savings account is the better choice, particularly if you're going to hold the money in the account for more than a few months.
• Watch for monthly fees. If a precise minimum account balance is required to have the fee waived, make sure you'll have at least that much in the account at all times.
• Fees are usually based on the average daily balance for the month. If you're moving funds in and out of the account regularly, you'll be charged the fee if your average daily balance doesn't meet the minimum.
• A monthly fee can nullify interest paid on a savings account. If you deposit $10,000 into an account that pays 0.60%, you'll earn just $5 per month. A $10 monthly fee will more than offset that.
• Know the bank's policy on excess withdrawals. Some will threaten to convert your account to a checking account, while others will charge you a fee for each excess withdrawal. But even those might convert your account if you do it too often.

What is a savings accouny interest rate?

A savings account is a type of bank account that pays you money to keep funds on deposit. Savings accounts, [certificates of deposit (CDs) and money market accounts all pay you based on the total funds in your account. And the rate they pay you is called an interest rate or a savings interest rate.

An interest rate is a percentage of the total balance. For example, if you have an account with $1,000 that pays a 2% interest rate, it would pay you $1.67 in the interest of the first month. It would pay a little more each month over time thanks to the power of compound interest.

We know it pays $1.67 because of this savings interest rate formula: $1,000 x [2%/12] = $1.667. That rounds to $1.67. The next month, you would earn interest on $1,001.67. So your interest is a little bit more. Over time, that effect can be huge.

Interest rates vary by bank, account type, and other factors. But you can't just look at a percentage rate and take it at face value. You need to know the APR and APY to make the most accurate comparison.

Current savings accounts interest rates

According to the FDIC's Weekly National Rates and Rate Caps report, the current average interest rate being paid on bank savings accounts is — get this — 0.07%. You didn't read that wrong; it's less than one-tenth of one percent.

When you consider the current rate of inflation is above 5%, you're losing money in a savings account at a typical bank.

But that doesn't mean you have to accept those barely visible rates. There are online savings accounts that pay at least 20 times as much interest. And while they won't make you rich, they'll at least keep your savings covered against inflation.

All of the online banks mentioned are offer some of the best high-yield savings accounts. Since they are available only online, they don't have to worry about maintaining branches like a traditional bank. They pass the savings onto you with much higher rates — in some cases, 1% or more higher than your local bank. Who can complain about that?

APR vs. APY

Savings interest rates are a percentage. You will typically see them shared as an APR (annual percentage rate) and APY (annual percentage yield). The primary difference is that APR is the actual interest paid, and APY includes the compounding effect.

This means you must compare APR to APR and APY to APY. You can't compare APR at one bank to APY at another and get an accurate comparison.

The best measure is generally APY because that is the effective rate you have at the end of a year at the current interest rate if you leave your money alone. After all, the point of a savings account is to keep your money for a long time, not just a short period, in most cases.

Why you need a savings account

Savings accounts are best used to hold funds you don't need to spend regularly — that's what checking accounts are for. But it isn't long-term money either. Since it probably has a near-term purpose — like a vacation, the down payment on a car or covering emergency expenses — you don't want to risk losing that money in an investment account should the market go down.

1. Emergency funds. This is usually the most common purpose of a savings account. You'll want to have sufficient funds in this account to cover occasional unexpected expenses, like major car repairs, medical expenses, or even a temporary disruption of income. Financial experts commonly recommend you hold three to six months' net income in an emergency fund. A savings account is perfect for this purpose since it keeps your money absolutely safe and reasonably accessible, and it pays interest.
2. Short-term savings needs. If you're planning to save money for a specific purpose, such as the down payment on a house or braces for your child, a savings account is perfect for you. Not only does it keep your money safe, but it also enables you to accumulate the funds over time. You can even set up regular payroll deposits to fund the account.
3. Custodial accounts. This can be an account you're holding for each of your children, at least until they're of legal age. It can be used to accumulate funds that will eventually be moved into an investment account. For example, you can use it to deposit gift money or money earned by the child from doing chores or from a part-time job. In the meantime, it keeps the money accessible, but not too accessible.

Do you pay taxes on interest from savings accounts?

One thing to keep in mind when dealing with savings account interest is taxes. The interest you earn from a savings account is reported via form 1099-INT. You have to include that income on your annual tax return with the IRS. Many banks, however, won't send you a form unless you earn at least $10 per year in interest.

Bank interest is taxed as ordinary income. That means you pay tax on the interest at your regular tax bracket's rate.

Savings accounts vs. money market accounts

In recent years, the differences between these two account types have seriously blurred. Both are interest-bearing accounts with no term limits. But the significant differences are that money markets typically pay higher rates of interest and offer greater access.

For example, you may be able to access funds from your savings account at an ATM using your checking account debit card. But the account won't come with a dedicated debit card. Money market accounts, on the other hand, often come with a dedicated ATM card and even paper checks.

But while money markets may offer more convenient access than savings accounts, they are similarly subject to Regulation D. even though your money may be easier to get; the limit is still six withdrawals or transfers per month.

Federal regulation D: the legal structure behind savings accounts

No discussion of savings accounts would not be complete without covering Federal Regulation D. It's the law that differentiates savings and checking accounts.

It involves two primary restrictions:

1. Reservation of right. This restriction requires the bank to disclose that it has the right at any time to require seven days' advance written notice of intention to make a withdrawal. But it's never imposed, which explains why the typical depositor knows nothing about it.
2. Limitations on withdrawals and transfers. Regulation D limits withdrawals or transfers from savings accounts to no more than six per monthly statement cycle. However, the restriction doesn't apply to all forms of account access.

Withdrawals and transfers that are subject to the limit include:

• Preauthorized, automatic transfers, including transfers from savings- account for overdraft protection or direct bill payments.
• Transfers and withdrawals initiated by telephone, facsimile, or computer.
• Transfers made by the depositor and payable to third parties. This can be made by check, debit card, or any other method.

Withdrawals and transfers that are not subject to the limit are:

• Withdrawals or transfers made in person at the bank, by mail, or by using an ATM.
• A withdrawal request initiated by telephone when the withdrawal is disbursed by check mailed to the depositor.

Some banks will hold the limit on withdrawals and transfers at six per monthly statement cycle. Others will charge some type of excess withdrawal fee, such as $10 per occurrence. But even when they charge a fee, they may still threaten to convert your savings account to a checking account if you make a habit of exceeding the limit.

Final thoughts on savings accounts

In recent years, many people have thought that savings accounts are no longer necessary. Some financial experts recommend being “fully invested” to maximize your return on investment. The companion argument is that credit cards can be used for short-term cash needs.

But while there may be some merit to that argument, maintaining adequate cash reserves for noninvestment purposes is a time-honored practice. As well, having sufficient cash available for immediate and near-term needs will prevent you from having to either liquidate investments or run up credit card balances.

That's the true function of a savings account and the reason everyone needs to have one. Be sure to choose the one that provides the best combination of high interest and no account fees.