dcsimg
Our articles, research studies, tools, and reviews maintain strict editorial integrity; however, we may be compensated when you click on or are approved for offers from our partners.

What is a Savings Account: Why You Need it

min read
The humble savings account is one of the most powerful financial tools available to help you reach financial goals.

piggy-bank-mazeDifferent from checking accounts that help you transact business with your money, a savings account is specifically designed to help you safely store and earn interest on your money.

Technically speaking, a savings account is a deposit account, usually federally insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC).

Banks offer several types of saving products like money market accounts, fixed investments and time deposits such as a certificate of deposit (CD). But the common savings account is certainly one of the most important accounts to have at any stage of life.

Purpose - Why You Need a Savings Account

The main purpose of a savings account is to offer account holders a convenient way to save money.

It is difficult to keep track of savings when they are co-mingled with general funds - and that makes it all too easy to end up spending money instead of saving it.

Another purpose is to earn interest on your savings.

Even though funds on deposit in a savings account are liquid (can be accessed when you need them), savings accounts usually come with restrictions. The most familiar savings-account restriction is Regulation D, which limits the number of withdrawals or outgoing transfers to six per statement period. If you exceed that limit, there is a fee.

You may think charging a fee to access your own money is onerous, but there are solid reasons for this regulation - and it can actually help you become more financially secure.

How Regulation D helps savers

Regulation D stems from the Federal Reserve. This rule requires banks and credit unions to impose fees or other penalties when you exceed the limit of six withdrawals per month per account. (Fortunately, ATM or teller deposits and withdrawals are not included.)

So how does charging a fee to access your money help you save?

If you think about it, Regulation D encourages savers to plan their withdrawals and overall finances. In effect, the fact that banks can charge an excess-withdrawal fee serves as a subtle deterrent to squandering your savings away on unnecessary things.

There is another purpose, looked at from a bank's point of view. Money in a savings account tends to be far more stable than checking-account balances. Therefore, the bank is allowed to hold back smaller reserves against those balances, which allows them to lend a larger percentage of savings-account balances.

Those loans are their main source of profit. When you see a bank advertise so many billions in assets, those assets are not buildings, but loans - because loans show on their books as assets (people owing them money).

In turn, banks pay interest on the deposits in savings accounts out of their profit. So this regulation fosters a kind of win-win proposition for both banks and savers. Savers are encouraged to keep their savings on deposit where they earn interest, and banks have a predictable source of funds for lending.

Does Finding the Best Savings Account Matter?

It's fairly easy to find and open a savings account; but by taking a little time to shop for a higher interest rate, you could save money faster.

"Competitive banks generally maintain the best rates over time," according to Richard Barrington, MoneyRates' Senior Financial Analyst, CFA.

MoneyRates.com specializes in monitoring the banking industry; and our studies show that the best savings accounts not only offer the highest interest rates, they do so consistently.

That's an important factor to remember when you're considering financial institutions, and here's why:

When banks offer high interest rates on a consistent basis,it's because they are making the choice to compete.

What that means for you is that, by finding one of the best savings accounts when you first open your account, you…

  • ... earn interest faster, and…
  • ... won't need to change banks in order to get the best rates.

All in all, finding one of the best savings accounts can pay off for you year after year.

How to Use Your Savings Account to Eliminate Debt

Financially successful people almost invariably have one or several savings accounts that they consider fundamental to their success.

But a lot of people have savings accounts. Does that mean all savings account holders are financially secure?

Not necessarily.

The secret is knowing how to use your savings account to accomplish financial goals, like eliminating debt or building a nest egg for retirement.

Think of it in terms of playing defense and offense in sports. Defense is where you are protecting your net worth and offense is where you're building it.

Savings Accounts for Defense

In the process of becoming financially successful, debt is the mortal enemy. One of the best ways to avoid debt is through the smart use of savings accounts.

Paying for emergencies

Say your furnace gives up the ghost on the coldest night of the year, and it'll cost $6,000 to fix.

A lot of people reach for their credit card at this point. And they know they'll be paying it off over the next year at a rate of $500 every month. For the first month, they'll have to add $145 in interest.

Ouch.

Over the year, they'll pay close to $1,000 in interest at prevailing credit card rates.

Obviously, the smarter way to handle your finances is, before said emergency strikes, to pay $500 a month into a savings account you set aside for emergencies. That's playing defense against paying unnecessary interest.

Financially successful people don't look at the microscopic interest rate the bank pays on that savings account. They see the $1,000 in credit card interest they'll save. Effectively, they are earning 29% on that money, in that they get out from having to pay it.

With an emergency fund, you can still pay the $6,000 bill with a credit card if you want the points - knowing that you'll simply pay off the credit card bill in full when it comes due at the end of the month.

The nice thing about an emergency fund is you don't know exactly which emergency will present itself.

It can be the furnace. It can be a car that breaks down. It can be a close relative's funeral in a far city. However, while we can't know the nature of the emergency, we know that life is life and some financially painful event can rear its ugly head, usually at the most inconvenient time. When that happens, having a savings account set up as an emergency fund ahead of time softens the blow, often by thousands of dollars.


Buying a car

Another example of the defensive use of a savings account is buying a car.

Cars are mechanical devices and they wear out, meaning it's a guarantee that they'll need to be replaced sooner or later.

Most people deal with this by taking out a car loan and making payments. Their monthly budgets are set up around those payments.

When the car is paid off, it's off to the dealer to get the next car, with the next set of payments - because they've become used to living with those payments. For the vast majority of Americans, making car payments is a part of daily (or rather monthly) life.

A better way, though, is by using a savings account, as follows:

Today's cars are built with sufficient quality that they usually outlast their payments.

Once the car is paid off, keep making those payments - only now make them into your savings account.

If your car payment was $500 a month, you'll have $18,000 in your savings account after three years. On top of the old car you're trading in, you either won't need a car loan for the new car, or you'll only need a tiny one. By keeping up this program, you'll be debt-free in no more than four years or so.

After that, you'll be able to buy a new car every three or four years without ever needing a car loan (and the monthly payment) again.


Taking vacation

The same principle applies to vacations. Many put their vacations on a credit card and pay it off over a year, in time for the next vacation.

If you're going to take that vacation every year, it's far better to put the same payment into a savings account. As with the emergency fund, you'll effectively earn about 20% or whatever the prevailing credit card interest rate is.

How to Use Your Savings Account to Build Your Nest Egg

The examples above can be viewed as using a savings account defensively to eliminate debt. However, there is another way one or more savings accounts can transform your finances from survival to prospering. Most personal finance experts agree there are four keys to financial success:

  • Earn more
  • Spend less
  • Avoid debt
  • Invest

Savings Account for Offense

The defensive use of savings accounts addresses the third item on the list. Smart use of savings accounts can also be a key in implementing the fourth step, which is the most important.

It is impossible to retire or become financially independent without a sufficient nest egg. "Nest egg" is just another term for "investment." Unless you want to work until you keel over, building up an investment base, therefore, is the most important key to a solid financial future.

Unfortunately, many of the investment options available to the person on the street require more to get started than they have available. For instance, most brokerage accounts require a minimum of $500 or $1,000 to get started. Another good investment opportunity might be buying rental real estate, e.g. the house next door. Unless you received a large bonus or inheritance, you might not have enough for the down payment.

A savings account is the ideal way to bridge that gap.

Savings accounts usually have no minimum to get started. That makes them the ideal staging ground. Simply put money - whatever you have - into a separate savings account, and keep doing that. Soon enough it will have the minimum you need to make that investment you've been eyeing.

Conclusion

The humble savings account may be the least glamorous of all the products and services financial institutions offer but, properly used, it can be one of the most powerful tools to help you achieve financial success. It is an excellent way to execute the strategic side of finance - buffering you from financial emergencies as well as helping build funds to invest as you work toward financial independence.

Compare Rates

0 Comment