Having a savings account is one of the best financial management strategies. The account allows you to save money for short-term and long-term financial goals and prevents you from spending every penny you make. Additionally, a savings account earns you interest, known as annual percentage yield(APY), essential for building wealth and reaching your financial goals faster.
Unlike a checking account designed specifically for spending, a savings account is designed to save money. If you are starting your savings journey, this article will explain what a savings account is, its benefits and drawbacks, and how it can help you achieve your financial goals.
What is a savings account?
A savings account is a deposit account you can open from a bank, credit union, or similar financial institution. It is great for storing money for short-term goals such as emergency funds or a car down payment. The Federal Deposit Insurance Corporation(FDIC) insures savings accounts up to $250,000, making savings accounts options for storing money and investing.
The biggest drawback of a savings account is that it earns a much lower interest rate than other deposit accounts, such as money market accounts(MMA) and certificates of deposit(CDs). Interest on savings accounts is variable, meaning it will change based on market rates. Online banks and credit unions offer higher-yield savings accounts than traditional savings accounts.
Most savings accounts allow you to make deposits and a limited number of withdrawals, usually up to six times a month.
What are the alternatives to a savings account?
Given the low interest rates of savings accounts, you may be wondering if there are alternatives to them. The answer is yes. There are better options with relatively higher interest than savings accounts, which also come with the same level of security for your funds.
The following are a few alternatives to savings accounts.
- Certificates of deposits (CD). Banks, credit unions, or other investment firms offer these accounts where you lock your money in the account for a fixed interest until maturity. After the maturity date, you can take your money out or renew your CD. As of September 2024, the national average rate for the 12-month CD is 1.85%, according to FDIC.
- Cash management accounts are similar to savings and checking accounts. However, nonbank firms offer them, and some of these institutions offer better rates than savings and checking account rates.
- Money market accounts (MMAs). Similarly to savings accounts, MMAs are offered by banks and credit unions and are insured by the FDIC, but they come with relatively better rates. However, according to the Consumer Financial Protection Bureau(CFPB), you cannot withdraw or deposit more than six times a month.
Benefits of savings accounts
- You will take advantage of a small interest, which is better than having the money in a checking account where you earn no money.
- The lack of direct access prevents you from similar overspending activities associated with checking accounts.
- The savings account allows you to save money for a future goal, such as buying a car, a house, or paying for college.
- It is easy to set up a savings account. Many banks and institutions offer the option of having both accounts (savings and checking) together so you can quickly transfer money from one account to another.
- Your savings account will be insured for up to $250,000 per depositor from a bank failure, according to the Federal Deposit Insurance Corporation (FDIC).
- Savings accounts are great for holding your emergency funds.
Disadvantages of savings accounts
- Savings accounts do not provide enough interest for your investment. According to FDIC, the national average interest for savings accounts is 0.46%. According to FDIC, this rate is too low compared to what you can get from a Certificate of Deposits (CD), which stands at 1.85% for a 12-month CD and 0.64% for MMAs. In addition, this return is nothing compared to the inflation rate, which stands at 32.9%, according to Statista. This means you will still lose more money over time through inflation by keeping your money in a savings account.
- You will have a limited number of withdrawals and deposits. The money you have in a savings account is not as accessible as in your checking account. To use money from savings accounts, you will need to transfer it into a checking account. According to Nerdwallet, the federal government limits you to at most six deposits or withdrawals from your savings account per month.
- Even if your money is in a savings account, you can easily be tempted to use it, especially if your savings and checking accounts are connected.
- Required minimum balance. Most savings accounts come with a minimum balance. Falling below that balance comes with charges.
What is the point of a savings account?
The main purpose of a savings account is to save for short-term financial goals and emergencies. The account allows you to earn interest on your deposited money while maintaining access to your cash as needed.
You might wonder if a checking account alone can help you achieve the same goals.
While this idea can be tempting, the money in your checking account is prone to excessive spending, and the account does not yield a return, making it the least choice for savings. By comparing a savings account vs. a checking account, a savings account stands out as a perfect option for keeping your money safe with some form of growth due to savings account APY. However, a checking account is ideal if you only need one to allocate cash for daily purchases.
Is a savings account worth it?
The benefits of having a savings account outweigh the drawbacks. A savings account allows you to save money, an essential step in achieving financial stability. Most people spend every penny they make because they don’t have a savings account or ignore saving money.
For example, many people with no savings accounts might not have an emergency fund. The lack of emergency funds means you could easily default on your loan, fail to pay off a sudden expense or become homeless due to a job loss. The lack of a savings account also means that your money is not growing as checking accounts do not come with interest, and you can easily spend all of it by the end of the month. Hence leading to a paycheck-to-paycheck lifestyle.
A savings account allows you to save for different financial goals. For example, if you are saving for a down payment on a home, a car payment, a wedding, or a dream vacation, it will be wise to put your money in a savings account rather than a checking account.
While having a savings account allows you to save for emergencies and financial goals, putting too much money in a savings account is not wise. A savings account still earns you a lower interest rate than other deposit accounts. By putting too much money in a savings account, a large portion of your money loses purchasing power due to inflation.
What are the risks of putting money in a savings account?
Putting money in a savings account is considered low-risk as the account is insured by either FDIC for insured bank accounts or NCUA for insured credit union accounts up to $250,000 per account and depositor. This means that even if the bank were to fail, you would still get your money back together with accrued interest up to the insured limit.
The hidden risks of putting money in a savings account are inflation-related. By default, the inflation rate is always higher than savings account annual percentage yields(APYs). This means that even if you earn interest on your savings account, you still lose purchasing power since your ROI lags the inflation rate. That is why it is best to put less money in a savings account and allocate the remaining funds to high-return investments that beat inflation to break even and build your net worth.
The other risk of putting money in a savings account is tax risk. Earnings from your savings account are taxed as ordinary income, and they can go as high as 37%, depending on your tax bracket. According to Investopedia, if you invest your money in a long-term investment, you can pay capital gains tax of 0%, 15%, or 20%, depending on your taxable income.
How much is too much in a savings account?
Putting money in a savings account is a smart way to save for emergencies and short-term financial goals. But, putting too much money in a savings account is not a good idea due to lower interest rates and the risks of inflation. If your deposit exceeds the insurance limit, you might lose the above-limit balance if the bank fails.
So, how much is too much? What makes a savings account attractive is the guarantee of your deposit through insurance provided by the FDIC and NCUA. The current coverage limit for both institutions is $250,000.
So, anything over $250,000 in a savings account will not be protected if the bank fails. For this reason, the highest you could reasonably put into a savings account is anything under $250,000.
Is putting $250,000 in a savings account a good financial decision? Keeping that much in a savings account is not a good idea due to the risk of inflation and low rates unless the money is in a high-yield savings account with an APY higher than the inflation rate. If you prefer a higher return, maintain a lower balance in your savings account and put your money in high-return investments.
If your main goal is to save for a particular goal, keep your emergency fund in a savings account and put the remaining balance in deposit accounts that offer higher returns, such as money market accounts, certificates of deposit, or high-yield savings accounts.
Is it better to save or invest?
Saving and investing are two essential steps for financial stability. Investing can potentially generate higher returns than savings accounts. However, you are exposed to more risks due to market fluctuations and high volatility. On the other hand, savings accounts allow you to achieve specific goals that would otherwise be difficult through investing. For example, a savings account is liquid, which makes it perfect for emergency savings. But, if you were going to use the money from investments to take care of emergencies, you might have to liquidate your investment at a considerable loss.
The best course of action is to invest and save simultaneously. Figure out the money you need for emergencies, which should be 3 to 6 months of your expenses, and put it into a savings account. If saving for a particular goal, put that money into a high-yield savings account or a money market account to earn a higher interest. Then, invest the rest of your money in stock funds, real estate, and bonds. This plan will help you grow your investment portfolio while meeting other financial obligations with your savings.
