How Does A Savings Account Work?

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When you make deposits into a savings account, you’re creating a safe place to store and grow your money. But how does it grow over time?

Each month, you earn interest based on the rate the bank pays, compounding and frequency. And interest isn’t the only benefit of a savings account—your money is also insured. It can be placed into a bank account backed by the Federal Deposit Insurance Corporation (FDIC). This covers both your principal and any interest accrued, up to the maximum amount allowed by law.

Depending on the bank where you open an account, there are different requirements that you must follow. This can include minimum opening deposits (which are as low as $1), minimum average monthly balances, monthly account fees, maintenance fees, and usually variable interest rates, some based on balance tiers.

Let’s dive into the specifics of how savings accounts work.

Why banks pay interest on savings accounts

When you deposit money into a savings account, your bank will compensate you by paying interest on your account. The bank will then use these deposits to lend money in the form of credit card lending, mortgages, personal or business loans and more.

Banks are usually the ones that determine their own interest rates, based on several different factors—such as the competition, market levels and federal policies. There are three main forces that determine banks’ interest rates: the Federal Reserve that sets the federal funds rate, the investor demand for U.S. Treasury notes and bonds, and finally the banking industry itself.

How does interest work on a savings account?

The annual percentage yield (APY) is the most important factor to research when opening a savings account. The APY shows how much you will earn on your money over the period of a year by factoring in your interest rate and the frequency of compounding interest. All banks must calculate the APY using the same calculation method based on their product. This way, consumers can make informed decisions knowing they are comparing apples to apples.

What is compound interest?

Compound Interest is known as “interest on interest.” Essentially, it is the result of reinvesting interest rather than paying it out. Interest can compound daily, monthly or annually, depending on each bank’s product. For example: If you take that same $1,000 but now it is compounded daily at 1%, you would have $1,010.05. A nickel may not seem like a huge difference, but if you deposited $100 a month for 12 months, your ending balance would be $2,216.05!

If you’re looking for a higher APY, you want to look for one that has frequent compounding periods. Below are some examples of estimated earnings based on APY:

Annual Percentage Yield
Est. Earning 1 YR (*$10,000)

Calculate estimated earnings with a PurePoint account.

Why should I open a savings account?

You may be thinking, why open a savings account if I already have a checking account? Savings accounts typically have higher interest rates than checking accounts that pay interest because savings accounts have more transaction restrictions on the movement of your funds.

Besides the better interest rate, savings accounts help you separate your everyday spending funds and the funds you may need for a later time. It’s important to set aside funds that you can’t easily access for long-term purchases, whether that be for vacation planning or a rainy day fund.

Here are some key differences from a Savings vs. Checking account:

Checking Account
Savings Account
Withdrawal Restrictions
Up to 6 limited withdrawals per statement period.
Minimum Balance
Varies by bank
Varies by bank
Designed For
Regular use
Long or short-term savings
Overdraft, ATM, foreign transaction fees (vary by bank or credit union)
Monthly maintenance fees, excessive withdrawal fees (vary by bank or credit union)
Interest Earned
Sometimes; rates vary by bank
Yes; rates vary by bank
Other Features (varies by bank)
Debit card, paper checks, direct deposit, online services, ATM access
ATM access, direct deposit, online services

How much should I be saving?

The amount in your savings account should align with your personal goals. How much are you saving for retirement? What are your monthly living expense in case of job loss? How much would you need for emergency car or home repair? Here are some common budgeting methods you should keep in mind when saving.

The 50/30/20

This is a popular rule of thumb that many savvy savers use. It involves calculating your after tax income and splitting it up into three percentages based on high to low priorities.

50% Needs

These are the payments that will severely impact your quality of life if not paid for. These expenses include groceries, utilities, insurance, auto payments, etc. Even paying the minimum payment on your credit card should fall under a “need.”

30% Wants

These expenses are going to be everyday enhancements that make your life more comfortable. Things like your phone bill, designer clothes, gym memberships, entertainment and more. It’s easy to overspend in this category, so it’s important to think about what you can and can’t live without.

20% Savings

This qualifies as paying off any debts you have, building up your emergency fund and saving for retirement. You don’t have to contribute to all three of these in the same month, but always make sure you are rotating and adding to these monthly.

3 to 6-Month Emergency Fund

Saving experts say you should save 3 to 6-months of your income for any unexpected emergencies. If this doesn’t seem completely possible, saving at least $500 is also a great starting point to start building.

Budget by Expenses

Created by David Ramsey*, this budgeting rule breaks up a percentage of your income and allocates it into eleven categories.

  1. Giving — 10%
  2. Saving — 10%
  3. Food — 10 to 15%
  4. Utilities — 5 to 10%
  5. Housing costs — 25%
  6. Transportation — 10%
  7. Health — 5 to 10%
  8. Insurance — 10 to 25%
  9. Recreation — 5 to 10%
  10. Personal spending — 5 to 10%
  11. Miscellaneous — 5 to 10%

While this is more of an outline, it’s still a great reference point to start. If you ever have to spend outside of these categories, just change the percentage in certain areas accordingly.

How to Choose a Savings Account

There are a handful of factors to take into consideration when choosing where to open a savings account.

  • Do you want a physical, brick-and-mortar location or do you prefer an online bank?
  • What are the savings APYs?
  • Are there requirements, restrictions, and fees?

At PurePoint Financial, we believe you should enjoy the rewards of earning more. Simply call our Client Support Center, or open an Online Savings account right from your computer, tablet or mobile device.

SOURCE: David Ramsey

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