How Does a Saving Account Work and Importance of Saving in Budgeting
Updated: Aug 18, 2020
Of all the adults in America, nearly 70% of them have less than $1,000 in savings. Now, lack of income can certainly be a factor, but many Americans simply don’t understand the benefits and basic principles of properly using a savings account. Unlike other countries, personal finance is not always taught to Americans who are about to become adults.
In fact, many American adults still live with the mindset of “If I earned it, then I should spend it!” oftentimes getting them stuck on a paycheck-to-paycheck cycle well into their 30’s and 40’s. Even as their income increases, their mindset quickly turns to “I’m earning more, so I should spend more!”
Learning both the benefits and the principles of savings can help you whether you’re 16 and just entering the workforce with your first job, or if you’re 60 and are finally learning to take control of your finances.
For those whose personal finances are not in order, the best time to straighten things out was yesterday. The second-best time to do so is right now. So sit back and take notes as we take you through something everybody should know: How a proper savings plan can benefit you and the basic principles that drive them.
Saving Accounts: What are they and how do they operate?
“Uhh, isn’t that just like a checking account except worse because they don’t give me a debit card for it?” -- On the surface that’s kind of true, but there’s so much more to it. Yes, a savings account is an FDIC-insured deposit account just like your checking account. Ideally a savings account pays you interest for keeping your money parked there.
Additionally, in order to encourage proper savings habits, the federal government restricts savings accounts to 6 withdrawals per month. Trying for a 7th withdrawal in the same month will either be stopped by your bank or you will incur fees and penalties. Savings accounts are a blessing that many people simply see as an inconvenience.
How do savings accounts pay you interest?
Whenever a typical bank, credit union, or financial institution gives a loan to somebody, the capitol they use is pooled from their deposit accounts. They are charging the customer interest on this loan and, in turn, give some of that interest back to their customers through their savings accounts.
Obviously they don’t take the money out of your account and give it to somebody else in the form of a loan. But this is another reason why savings accounts are limited to 6 withdrawals per month. This is also why many banks failed during the great depression when people ran and withdrew all of the money from their accounts.
How do I find a good savings account?
Savings accounts are heavily regulated by the federal government so there are only a few variables that come into play, otherwise they all act exactly the same. So what are those two variables?
Yield / Interest Rates - The interest rate on a savings account will most certainly fluctuate based on the economy. Back in 2007-2008 just before the housing market crashed, there were some savings accounts in Capital One that paid 4.5%-5.25% interest. As of April 2020, Capital One’s highest yielding account will get you 1.5%-1.6%. That’s about the going rate for any high-yield saving account. Many local banks will only pay out 0.1%-0.25% so shop around and find the best rate. Your money can’t work for you without interest!
Fees & Penalties - As we mentioned before, savings accounts are very heavily regulated. The government has allowed banks the ability to charge fees in a few very specific areas: new account fee, monthly and/or annual maintenance fees, and minimum balance requirements. The whole purpose of saving and earning interest is defeated when your balance is eaten up by fees. Shop around and find a bank that will not charge you to park your money with them!
What is the best high-yield savings account?
This one can come down to personal preference. The industry is pretty competitive right now which means that there are plenty of big-name institutions out there offering a decent yield with no startup costs or monthly fees.
A good first step should always be to check with your local credit union, and maybe the same bank that your checking account is opened up with. Compare interest rates and thoroughly research the costs and fees involved. Always make sure to ask about opening deposit amounts and minimum balance requirements.
And, if you aren’t satisfied with what the local guys are offering, then consider one of the big-name online high-yield account providers Here are some popular suggestions in an unbiased, non-specific order:
Personal Savings: Other options outside of traditional savings accounts
To start saving, you don’t always need a traditional savings account. Taking control of your personal finances goes way beyond the realm of an actual savings account. There are plenty of other wonderful options available.
As we mentioned earlier with interest rates, they just aren’t quite as high as they used to be. One of the huge benefits to a savings account is that your money is safe and is FDIC insured.
Below are some alternatives that, while they aren’t guaranteed by the FDIC, they will certainly out-perform a traditional savings account. These may be good options for those who have more than $1,000 that they’re starting with and won’t necessarily need the liquidity that comes with a savings account.
Money Market Accounts* - These are similar to a savings account except you essentially trade a higher rate for more restrictions on minimum balance requirements and monthly withdrawal limitations.
Certificates of Deposit (CDs)* - Getting a certificate of deposit is a great plan if you can afford to set your money aside and not touch it for ideally a year or more. They traditionally earn much higher guaranteed interest rates.
Roth IRA - For those looking for a long-term savings option and aren’t afraid to weather the ups and downs of the market, a Roth IRA is a great option. As a bonus, your patience can potentially be awarded with tax-free withdrawals.
High-Yield Checking Accounts - Yes, believe it or not, there are checking accounts that earn a higher yield than traditional savings accounts. The caveat here is that they often require a much higher minimum month-to-month balance.
I-Bonds - Sold by the U.S. Treasury Department, an I-bond’s rates are often higher than savings accounts and are based on the rate of inflation (hence the ‘I’ in I-bond). Like the CDs we mentioned above, these are highly time-dependent instruments. I-bonds can earn generous tax-free interest for up to 30 years before maturity.
*FDIC insurance covers checking accounts, savings accounts and certificate of deposits. Banks also may offer what is called a money market deposit account, which earns interest at a rate set by the bank and usually limits the customer to a certain number of transactions within a stated time period. All of these types of accounts generally are insured by the FDIC up to the legal limit of $250,000.
The Basic Principles Behind Savings & Growing Your Nestegg
Now that you know the basics of how savings works, where the interest comes from, and what types of accounts are available, let’s take a look at the basic principles behind properly and successfully saving in order to improve your personal finance skills and grow your net worth.
Principle 1: Know Your Budget Now and Reevaluate Your Budget In The Future
The main factor being saving properly is knowing how much you can afford to save. You should sit down and take a long, hard look at your necessary bills and spending habits. If most of your purchases are made with credit and/or debit cards, an app like the Mint App will help you take a deep look at your spending habits.
A key trait that many wealthy people share in common is that they are very meticulous with their spending. They know exactly how much they bring in, they know just where that money goes to, and they always stick to a strict budget. Proper financial planning begins with knowing how your money is being spent.
Principle 2: Compound Interest: A Millionaire’s Best Friend
A wealthy person that says “make your money work for you, and not the other way around” is oftentimes referring to compound interest. A simple-interest account will only earn interest on the principal balance. A compound-interest account will earn interest on both the principal and the interest that has already accrued.
Once you learn to take advantage of compound interest your money will truly be working for you, rather than you working for your money. Using compound interest and the magical number of 72, you can see how often your money should double.
Let’s say your money is in a fund earning a generous 8% interest. Dividing that by 72 gets us 9. This means at 8%, your money should double every nine years with compound interest.
A young boy’s parents but $4,800/year away for him when he was a child. When he turned 18 he had $86,400 waiting for him. He put this money into a fund that earns 8% and utilized compound interest. Assuming he didn’t touch the money and never invested or saved a single penny himself, here’s how that money would grow with compound interest:
18 years old - $86,400
27 years old - $172,800
36 years old - $345,600
45 years old - $691,200
54 years old - $1,382,400
And, again, that’s assuming he never saves or invests a single penny into the original fund himself. A mere $100/month addition would have added almost $250,000 more to his final nestegg
Play around with the compound interest calculator to get an idea of why compound interest needs to be your new friend.
Principle 3: Savings ANYTHING Is Better Than Saving NOTHING
Many people get discouraged from saving because once the bills are paid, they’ve only got an extra $50-$100 laying around. That often gets left into checking or spent on something unnecessary before the next paycheck comes in.
Saving anything of any amount right now is infinitely better than saving nothing. You will not get out of the paycheck-to-paycheck cycle if you don’t start putting something, anything, away right now.
Principle 4: Lifestyle Inflation: BEWARE
Let’s say you have finally been able to sit down and carve out a budget based on your income and monthly expenses. You’ve been doing great and over the last year or two have put away a decent chunk of money by staying disciplined.
All of a sudden you get a raise! That’s great, congrats! Many adults will see this raise as a chance to take advantage of ‘lifestyle inflation’ whereby they simply spend more because they’re earning more.
It makes sense, right? You’re earning more so you can spend more while still meeting the savings goals you set forth before the raise. There’s nothing wrong with treating yourself to something nice if it’s within your budget, but extra income means you need to re-think your budget. Spending more because you’re making more is a great way to miss out on a potentially huge financial opportunity that can pay off for you in the future.
It doesn’t matter how much we educate you on the subject, and it doesn’t matter what your personal and financial situation is at home, saving money is hard work for anybody. With such outrageous consumer spending it’s so easy to want to spend money the second you earn it. Nobody wants to sit down and think “okay, I can afford my $500/mo car, but if I downgraded I would have an extra $175/mo to put into savings.”
Let’s face it though, the likelihood of you striking it rich or winning the lottery is extremely low. It is possible to be rich later on in life if you start savings now, and are saving the right way.
Just get in the habit of budgeting and saving now. Don’t spend too much time early on wondering just how and where to invest your money.
The first step is to get into the actual habit of setting money aside, and having the discipline to not touch it. Once you’ve mastered that, everything will eventually start falling into place.
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