If the only type of bank account you have is a checking account, you’re missing out. Open a savings account, and you’ll be able to set aside money for emergencies in a place that’s slightly harder to access than your checking account. You’ll also be earning a little bit of interest so that your money doesn’t lose too much value over time from inflation.

What’s more, the bank’s own security measures, along with The Federal Deposit Insurance Corporation (FDIC), will keep your money safer than it would be under your mattress or in your sock drawer. This guide will teach you everything you need to know about how savings accounts work and give you more details about why you might want to open one. It will also point out where savings accounts fall short and how you can do better.

(To learn more, read our tutorial, Savings Accounts 101.)

What Is a Savings Account?

A savings account is a record of the money an individual holds in an interest-bearing deposit account at a bank. Two key features set savings accounts apart from checking accounts.

These accounts generally pay a higher interest rate than checking accounts. If a checking account pays 0.01% interest per year, a savings account might pay 1.00% interest per year. The interest rate depends on the bank, on economic conditions and, sometimes, on how much money is in the account.

Also, savings accounts limit the number of certain types of transactions the account holder can perform each month because of a Federal Reserve rule called Regulation D. Limited transactions include transfers between accounts, bill payments, overdrafts, and check or debit card transactions. If you exceed the limit, the bank may charge you a fee, close your account or convert it to a checking account.

Why Open a Savings Account?

Why would you open a savings account? If you won’t need the money in the short term, you’re better off putting it in an account that earns interest. Our money is always losing value thanks to inflation, which runs about 2% per year. If your savings are earning interest at 1% per year, your money is still losing value, but not as quickly.

To keep up with inflation or outpace it, you’d have to put your money somewhere less accessible, like a certificate of deposit (CD) or a savings bond. A CD is a type of savings product issued by banks and other financial institutions. CD's usually pay a slightly higher rate than most savings accounts but your access to the funds are limited. A savings account is a third-most accessible place to keep your money after cash and checking accounts.

Less Access Equals More Savings

Putting your money in a slightly less accessible place can help prevent you from spending it on things you don’t need. Having savings set aside also gives you at least a partial solution to various problems that might come up in your life, such as a car repair, an emergency vet bill, a medical bill, or even unemployment.

If you’re just starting out, set a manageable goal, like $100, for your savings account. Then gradually set the bar higher: to $500, then $1,000, then three months of living expenses, then six months of living expenses. Having six months of expenses in your savings account will prepare you for most unexpected financial difficulties. However, for more serious emergencies, you’ll want various types of insurance, like disability income insurance and health insurance.

Further, taking money out of your savings account to pay for these things is a much more affordable and reliable solution than using a credit card. Credit cards tend to have higher interest rates, and once you start carrying a balance, compound interest can make a very deep credit hole to dig out of debt.

Plain Vanilla Savings Accounts

The most common type of savings account is a plain vanilla one, though banks won’t call them that. A plain vanilla savings account is simply one that pays you a flat rate of interest no matter how much money you have in your account. These accounts have the restrictions mentioned earlier on how often you can move money into and out of your account.

A plain vanilla savings account can also be a linked savings account that is connected to your checking account at the same institution. The purpose of linking your accounts is to allow you to quickly and easily move money between the two accounts. A linked savings account may earn a higher rate of interest because the bank may take the combined balance of your checking and savings accounts into consideration when determining what interest rate your balance earns.

Tiered-Rate Accounts

A savings account that earns a higher interest rate at higher balance levels is called a tiered-rate account. You might, for example, earn:

  • 0.5% on balances of $0 to $5,000
  • 1.0% on balances of $5,000 to $15,000
  • 1.5% on balances of more than $15,000

Tiered rates reward customers who keep high savings account balances. But consumers should be careful not to keep more money than they need for a six-month emergency fund in their savings account. Excess funds could be earning a higher interest rate by investing in other investment products.

Paying the IRS

The interest you earn on your savings is, unfortunately, taxable in most cases. This tax makes it even harder to keep up with inflation. Certain accounts, such as health savings accounts (HSAs), get around this problem. These options have more requirements than regular savings accounts. For example, to contribute to a health savings account, you need to have a high-deductible health insurance plan.

The financial institution where you hold your account will send a 1099-INT form at tax time anytime you earn more than $10 in interest income.

Consider Interest and the Fees

Interest is the money a bank pays you in exchange for keeping your money there. Banks can afford to pay interest to depositors because they make money by lending out deposits to other customers as personal loans, mortgages, lines of credit, small business loans and more. Because banks don’t actually hold 100% of the money customers entrust them with, bank runs – large numbers of depositors taking out their money – can be problematic. This is why the Federal Deposit Insurance Corporation (FDIC) was created to protect depositors. (The FDIC insures deposits for up to $250,000 for each account category and each depositor.)

The level of interest a bank pay to their saving accounts customers is one method that banks compete with each other for business. To score the highest rates, you need to shop around. It’s also important to take the bank’s account fees into consideration in order to see where you’ll come out ahead overall. A monthly maintenance fee could easily cost more than the interest you earn.

Here’s a basic example of how interest works. Let’s say you have $1,000 in your account at all times and the bank pays 1% simple interest per year. At the end of the year, you will have earned 1% of $1,000, or $10, in interest. If you deposit no additional funds, your balance at the end of the year will have increased to $1,010.

How Compound Interest Works

However, most banks pay compound interest and not simple interest. When you shop, look at if the bank pays compound interest and how often they compound the value. You want to earn compound interest because it means you’ll earn interest on interest. That will make your money grow faster, and you will end up with more money in your account.

It’s common for banks to offer interest compounded daily. Here’s how this works. Let’s say on Jan. 1, you have $10,000 in your account, and the bank pays 1% interest per year. There are 365 days in the year, so you earn 0.00274% interest per day. That means your interest for Jan. 1 will be 27.4 cents. Now your account balance is $10,000.27. Your interest for January 2 will be calculated on $10,000.27, not on $10,000.00, so you’ll earn a tiny bit more. By the end of the year, compound interest of 1% on $10,000 will earn you $11 versus $10 for simple interest.

No, compound interest doesn’t make a big difference when interest rates are super low or on an account with a low balance. But it’s worth knowing about because it has a big effect when you have a larger amount of money earning significant returns, such as in a retirement savings account that’s invested in the stock market.

Where to Open a Savings Account

You have options when choosing where to open a savings account. You can choose a bank or a credit union. Further, you can choose an institution that offers physical branches or one that only has an online presence. If you’re purely concerned with earning the highest possible interest rate, online-only institutions often pay more competitive rates. Presumably, online-only institutions have lower overhead costs since they don’t operate physical branches, which allows them to pass on more of their earnings to their customers in the form of higher interest rates.

For example, as of early October 2018,

  • PurePoint Financial was offering an annual percentage yield (APY), on a savings account of 2.13%. However, you needed a minimum balance of $10,000 to earn this rate.
  • Vio Bank was offering 2.11%, with a $100 minimum balance.
  • Northfield Bank offers a 2.25% APY with a one-cent minimum to open

Other institutions that paid higher interest had no minimum balance requirements. The following banks all paid 1.90% APY: American Express National Bank, Barclays Bank, Synchrony Bank, and Goldman Sachs Bank USA.

Watch Out for Bait and Switch

Some financial institutions will offer high initial rates but may limit your access to the funds, drastically drop the rate after a period, charge additional management fees, or may require you to hold an account with them for a specified period. Sometimes, you can find an above-average interest rate designed to attract new customers.

As an example, in early October 2018, Digital Federal Credit Union (DCU) was offering 5.12% APY on the first $1,000 deposited. Open an account at DCU and you would earn a little over $50 for the year on the first $1,000 of your account balance. However, the remaining account balance would only earn 0.25% APY, which is significantly lower than the most competitive rates out there. As a result, you might not come out ahead with a deal like this depending on how much money you deposited. If you kept $1,500 in the account all year, for example, you’d earn a blended APY of 3.5%, which is still a great rate. Be sure to read and understand the small print before you sign on the dotted line.

Credit Union Accounts

Credit unions, unlike banks, have membership requirements. Some are open to everyone, and some are open only to members of certain groups, such as military service members and their immediate families. There’s often a small fee to join and a small balance requirement, such as $5, to remain a member. Despite these restrictions, many people prefer credit unions to banks because they can be more customer focused as opposed to shareholder focused.

What about the online-only vs. brick-and-mortar question? If you don’t need to visit a teller in person, if you don’t mind using mobile check deposit, and if the bank has a good ATM network where you can make free withdrawals – or has a reasonable ATM fee reimbursement policy – there’s little reason not to go with an online-only bank.

Economic Factors and Savings

The interest rate that a savings account pays depends on two interest rates set by the Federal Reserve Bank: the federal funds rate and the discount rate. The fed funds rate is the interest rate banks charge to lend money to each other. The discount rate is the rate banks pay to borrow money from the Federal Reserve. The Federal Reserve lowers these rates when it wants to stimulate economic growth and raises them when it wants to curb inflation.

As of October 2018, the federal funds rate had a target range of 2.00% to 2.25% and the discount rate was 2.75%. The highest-paying savings accounts are offering to pay customers a rate on deposits (which, as noted above, they lend out to other customers to make money) that's on par with the rate they would pay to borrow money from another bank. In general, banks will not offer customers an interest rate on savings accounts that's much higher than the rate they would pay to borrow money from one another or from the Federal Reserve. 

Special Savings Accounts

Banks and credit unions may offer special savings accounts to attract certain types of customers who might otherwise be hard to attract, such as investors (who know how to earn higher interest rates elsewhere) and children (who don’t have much money and might prefer to spend it all on candy and video games). What features do these accounts offer, and are they really that much different from a regular savings account? Or are they just a marketing gimmick?

Investor Accounts

Here’s an example. As of May 2018, BB&T bank was offering the Investor’s Deposit Account geared toward customers with deposits of at least $10,000. But it offered a laughably low-interest rate of 0.02%.

Charles Schwab Bank offers an account called High Yield Investor Savings. It pays 20 times as much as BB&T’s account, at 0.45%. But that’s still much less than you could earn at any of the top-paying institutions we mentioned earlier.

We aren’t saying that all savings accounts that call themselves investor savings accounts offer poor interest rates, but we are saying that you should look beyond the marketing and see what you’re actually getting.

Accounts for Children

Savings accounts for children can be a great way to teach your kids about banking and about the importance of setting aside money for the future. In October 2018 accounts with competitive interest rates were available at Capital One Bank and Alliant Credit Union. That being said, if your child will only be keeping a small sum in the account and your main goal is to use it as a learning tool, a low-interest rate might not be a deal breaker.

Instead, prioritize accounts with no minimum deposit requirement and no monthly fee. A children's savings account should allow parents to set ATM withdrawal limits and determine how much control the child has over making deposits, transfers, and withdrawals. For convenience, you might want your child’s account to be at the same bank as yours, as long as the fees aren’t a deal breaker.

Once your child has saved enough for the interest rate to matter, you might consider introducing him or her to other low-risk but higher-earning savings vehicles, such as CDs and U.S. Treasury bonds. This knowledge will serve your child well throughout his or her life.

Holiday Accounts

Some banks and credit unions also offer Christmas club or holiday savings accounts specifically to help people save for the holidays. Though not as common as they once were, if you can find one, you’ll see that it works by encouraging you to make regular deposits throughout the year and charging you a penalty and taking away all the interest you’ve accumulated if you withdraw money before a set date.

Health Savings Accounts

A health savings account (HSA) is available to anyone with a high-deductible health insurance plan. In 2018, that’s a plan with a deductible of at least $1,350 for an individual or $2,700 for a family. In addition, for in-network services, the plan must cap out-of-pocket expenses at $6,650 for an individual or $13,300 for a family.

If you have a plan that meets these criteria, you can open an HSA. This account comes with a major benefit: You get to fund it with pre-tax dollars. A self-only plan has a contribution limit of $3,450 and a family plan has a contribution limit of $6,900 in 2018.

The money you deposit can be used to pay for deductibles, copayments, coinsurance and some other medical expenses. You can also invest the money and let it grow without paying taxes on your earnings – as long as you only withdraw the money for medical expenses. You can even use an HSA as a long-term investment to supplement your retirement savings.

(For more details on how HSAs work, read Health-y Savings Accounts.)

Can Foreigners Open Accounts?

The stability of the U.S. dollar and of the U.S. banking system make American bank accounts an attractive place to store money, especially for people from other countries with more volatile currencies and less sound financial institutions. As a foreigner residing outside of the United States, the easiest way to open a U.S. bank account may be to use a bank that has a physical presence in both the United States and in your home country (Citibank or Santander Bank may be options, depending on your location). Your home country may be able to provide the identity verification that U.S. banks require under Know Your Customer and Anti-Money-Laundering rules.

Foreigners who are already in the United States or who will be traveling here soon may find it easiest to visit a bank branch in person to open an account. First, find out what documentation the bank will require you to submit. At a minimum, you’ll need state identification, such as a passport, plus a secondary form of identification. Bring originals, not copies. You may also need proof of address, proof of funds and proof of employment. Citizens of certain countries that the United States is not on good terms with may not be able to open a U.S. bank account.

Americans and Savings Abroad

Americans who live abroad or who travel overseas frequently may find it easier to have a local savings account. You may save money in exchange fees and foreign transaction fees and have an easier time getting paid if you’re earning money abroad. The U.S. government does not have a problem with Americans keeping money overseas, as long as they comply with Foreign Bank and Financial Accounts reporting requirements and pay all the taxes they owe the United States government. Before you hop on a plane, make sure to pack the documents the overseas bank will require for you to open an account.

The Bottom Line

Opening and managing a savings account is easy to do. It’s also a good way to create more financial security for yourself. The key things to look for are convenience, low fees, and a high-interest rate – and always keep your money in a bank that’s FDIC insured or a credit union that’s insured by the National Credit Union Share Insurance Fund (NCUSIF), which is administered by the National Credit Union Administration (NCUA). All federal credit unions and the majority of state-chartered credit unions are covered by the NCUSIF protection.