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Your questions answered: How does a savings account work?

What we'll cover

  • How a savings account can be used and what it offers

  • Alternatives to a savings account

  •  Benefits of opening a savings account

As kids, many of us saved all our coins, dollars, and allowance in a piggy bank — and that was our first introduction to how to save. In many ways, a savings account functions a lot like a piggy bank. It’s a place to store your hard-earned cash until you might need it. But unlike your childhood piggy bank, a savings account can provide interest, meaning your money has potential to grow while it’s tucked away. So, how exactly does a savings account work?

A savings account is a type of bank account where you store money that you've earned — but with the added benefit of earning interest on that money.

We've got the answers about how the interest rate, annual percentage yield, and more factor into a savings account. Read on to discover how this “piggy bank” can inform your saving goals.

What is a savings account?

A savings account is an interest-bearing deposit account held at a bank or other financial institution. It’s a safe place to store cash, earn interest on your funds, and keep your money accessible.

A savings account is also a secure place for you to save your money for a later date (a big European adventure or a down payment on a house) and can serve as your emergency fund. And if a short-term need should arise (a busted water pipe in your kitchen or unexpected car repairs), you can immediately transfer the needed funds from your savings to a checking account to get out of a pickle.

What important features does a savings account offer?

Compound interest: Savings accounts accrue compound interest. When building wealth, compound interest is your best friend — that’s because it allows you to earn interest on your principal and your interest, and your balance grows faster. Some banks compound interest monthly, quarterly, or even annually. Look for a bank that compounds daily, like Ally Bank, to maximize your savings.

Interest rate: This is how much money you’ll earn on your savings. Online banks don’t have to support expensive brick-and-mortar branches, so they can usually offer more competitive rates.

Annual percentage yield: When researching your savings account options, look for one with a high interest rate, but focus on the annual percentage yield (APY), which gives you the most accurate idea of how much you could earn since it takes into account the frequency of compounding.

Minimal fees: Savings accounts often have low or no fees. When they do have fees, they may be small (think: a dollar a month). In some cases, they may be higher or even based on your account balance. Common savings account fees include:

• Monthly maintenance fee

• Service charges on the account

• Minimum balance requirement (Some banks may only charge a fee if your account balance falls below a pre-determined amount at any time, so keep an eye out for these requirements.)

Safety: If your bank is a member of the Federal Deposit Insurance Corporation (FDIC), your savings accounts are insured, which means the money in your account (up to certain amount) would be protected if the bank failed.

Learn more about FDIC coverage limits and how to maximize your protection here.

What are the alternatives to savings accounts?

Similar to savings accounts, these accounts also pay interest (and may be FDIC-insured, depending on the bank).

Money Market Accounts: These accounts generally pay a more competitive interest rate than checking accounts, but not as good as a savings account. Other benefits of a Money Market Account can include a debit card or the ability to write checks, but transfers and withdrawals may be limited to a few per month.

Certificates of Deposit (CDs): A CD is usually a fixed rate deposit account with a fixed term. Generally, the longer the term, the more competitive the rate (terms can range from a few months to several years). Keep in mind you are not permitted to withdraw money from a CD until the term is over and the CD matures — if you do need to withdraw the money, you will have to pay a penalty fee. If you want to avoid a penalty, some banks do offer CDs that allow for early withdrawals under certain conditions, like our No Penalty CD.

Why should you have a savings account?

You might be wondering why you would choose a savings account over another type of account. There are numerous reasons, including:

1. Since you can’t just write a check on a savings account, it helps create distance between your everyday spending money that you keep in your checking account and the funds meant for a later date or longer-term goals.

2. It’s a great place to keep your emergency fund (best practice is to have three to six months’ worth of living expenses on hand). Since the funds are liquid, you can easily access them should you need to.

3. Your money earns interest without you having to put in any legwork. By simply leaving it there, your funds will grow.

4. You can trick yourself into saving by having money deposited directly into a savings account from your checking account. Ally makes it even easier to do so with recurring transfers.

5. A savings account can help you meet longer-term financial goals and instills a sense of accomplishment when you achieve those goals.

How can you be successful with a savings account?

Building wealth with a savings account requires just a little planning. To get started:

 • Set a savings goal.

 • Research your options, including interest rate and APY.

 •  Consider online banking for its competitive rate advantages.

 • Find a bank that compounds interest daily.

• Commit to regularly saving — even a little bit can go a long way.

With these parameters in mind, your piggy bank will soon be working in earnest for you. All those kid-sized savings lessons you learned when you were younger will pay off in spades when investing with adult-sized strategies.

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