Alright, gather round. This is going to be important.
You’ve got your checking account set up and know how it works. You understand what interest is, generally, and what compound interest is, specifically. Now, how do you actually go about saving, investing, and getting your money to make you money, like we talked about?
Right, I want to start earning interest. How do I do that?
The simplest way to get your money to make money for you is to just open what’s called a ‘savings account’. As luck would have it, if you already have a checking account, you may already have a savings account too! Many banks will automatically open a savings account for you when you open your checking account, so check with your bank to see if they’ve already set one up for you. If they haven’t, it’s easy to set up and can usually be done over the phone or even in the bank’s app.
So I either already have the savings account or can get one easily. What’s next?
Well, savings accounts aren’t too much fancier than regular checking accounts. You can deposit money, withdraw money, transfer money, etc. just like a checking account. The most obvious difference is that savings accounts always pay a guaranteed interest rate, unlike many checking accounts.
Is it really that easy? I just deposit money into the savings account like I normally do with the checking account and…poof I’m making interest money?
Yeah, pretty much! You put the money in and the bank pays you interest every month.
Is it a lot of money?
Nope. Not for your basic savings account, anyway. The good news is, you can make more money in interest by going with a different kind of savings account.
Among the various types of saving accounts, there are 3 main types:
- Regular old savings account
- High-yield savings account
- Money market account
I’ll walk you briefly through each one.
Regular old savings account
This is your granddaddy’s savings account. These savings accounts have been around forever and are likely the ones that will be bundled with checking accounts. They are no-frills and usually no-restrictions. This means you can put money in and take it out anytime, like a checking account, but there won’t be too many account features and the interest you earn will be low. Still, you get this account for essentially no extra effort, the minimum deposit needed to keep it open is usually very low (like 5 bucks), and you still earn some guaranteed interest, which is the name of the game.
High-yield savings account
This kind of savings account is similar to the regular one, but it pays you more interest. That’s what the ‘high yield’ part in the name means. High yield = high(er) interest! Of course, you’re still not making a ton of money here, but it’s better than a regular savings account or checking account.
Now, why would the bank just give you more interest? Well, because there are strings attached of course! Usually these kinds of accounts have certain restrictions on them. Things like a higher minimum balance to keep the account open, or a limited number of withdrawals per month. So that’s not great, but if you don’t need to take out the money in your savings account frequently, you can make that higher interest without doing any extra work!
Money Market Savings Account
Lastly, there are the money market savings accounts. These are basically a special kind of high-yield savings account. See, back in the day, banks weren’t allowed to offer high interest rates on savings accounts, but other non-bank institutions could. After some good, old-fashioned lobbying, Congress changed the law and let banks offer much higher savings rates that could compete. These new accounts were called ‘Money Market Savings Accounts’ and the rest is history.
These accounts offer even higher interest rates than high-yield savings accounts, but will almost always have fairly strict restrictions like a low number of maximum withdrawals per month (e.g., 6 or fewer), minimum balances to keep the account open (sometimes as high as $1,500 or even more!), and sometimes even fees on top of all that! Still, the interest rates can be high enough to justify all these drawbacks, and money market savings accounts can really help you earn quite a bit more than the other options.
Got it. Now, with a checking account I have insurance if the bank goes under. Is the same true for these savings accounts?
Great point. And yes! all these types of savings accounts are insured via the FDIC or the equivalent insurer for credit unions, just like checking accounts. If the bank you’re with goes under, the money in these accounts will be paid out to you up to $250,000 per person, per bank. So fear not, these are safe options for growing your money.
Why Savings Accounts Make you Money
All that sounds great, but something’s bothering me. Why would banks pay interest on savings accounts in the first place? Savings accounts kind of sound like checking accounts, and checking accounts usually don’t pay interest. So why do savings accounts?
It comes back to risk for the bank. A checking account is a ridiculously risky asset, because the full amount in the checking account can come “due” at any moment. I.e., you can demand all your money and the bank must pay you all of it. So, most banks don’t want to pay anything extra on checking accounts as a result.
Regular savings accounts are a kind of “loose promise” to the bank that you won’t pull your whole savings account at any moment. That is to say, just having a savings account implies that you want to save the money in the account and you aren’t going to spend it all anytime soon. Given this “loose promise”, the bank is willing to accept a bit of risk and pay you for depositing money with them in a savings account. The bank can then loan that money out to others with at least a little guarantee that they won’t have to immediately pay it all back.
That’s also why interest rates, though guaranteed, are low on regular savings accounts: they’re still pretty risky for the bank.
Right, because I can still take my money anytime.
Exactly. Sure, you’re implying you won’t take your money out at any time, but you definitely could! You never signed anything saying you wouldn’t. So there’s still a good amount of risk involved for the bank.
The high-yield and money market savings accounts, on the other hand, pay higher interest because they’re lower risk for the bank. The minimum amount required to keep the account open means it’s very unlikely you’ll pull all of the money all at once. Add that to the limited withdrawals allowed each month, and these higher-yield savings accounts are a much more “firm” promise that you won’t just take your money and run. So, since you put up with the additional restrictions, you’re considered lower risk, and the bank pays you more in interest for your trouble!
But which one should you choose?
All that makes sense, but there are at least 3 main options. Which one should I go with?
Well, everyone’s a little different and everyone’s needs are a little different, so ultimately, it’s up to you and your situation. I’ve got some general tips and strategies for choosing and managing savings accounts though. More about that in the next article.
Thanks for reading.
Common Cents 