Savings Accounts –– The Benefits and Drawbacks of It, and Everything Else You Need To Know

What you need to know in order to get started with a savings account

Once you get started putting money away for retirement, you might start to wonder where you should keep your nest egg. Savings accounts are frequently the first option that people consider, but are they also the best option? Which type, out of all the available options for accounts that accumulate interest, will give you the greatest return on your investment? Take a look at some of the benefits and drawbacks of having a savings account, as well as four alternatives worthy of consideration.

The Benefits and the Drawbacks of Savings Accounts

Savings accounts –– the advantages

  • The interest you make on it
  • It is simple to open.
  • Funding that is readily available.
  • FDIC-insured
  • Low risk

Savings accounts –– the disadvantages

  • Fees
  • Low yearly percentage yields overall (APYs)
  • There are no tax benefits.
  • Restrictions placed on the account
  • The FDIC insurance only goes so far.

Explaining the advantages of savings accounts

The interest you make on it

There is a chance for you to be able to earn interest on the money you deposit into a savings account. Traditional savings accounts typically offer a quite modest APY. Online-only savings accounts typically offer annual percentage yields that are significantly higher than those offered by traditional savings accounts—sometimes up to ten times as high as those offered by traditional accounts.

It is simple to open

Opening a savings account is typically a simple process. In many instances, one can complete the application and subsequent steps in a matter of a few minutes entirely online.

Funding that is readily available

The money in your savings account is always available to you, making it convenient to use. When compared to putting it in a certificate of deposit, the money is allowed to remain liquid and is not constrained by a particular time period (CD). You can often manage your money online and schedule withdrawals or transfers according to your requirements (although withdrawals may be limited).

FDIC-insured

The money in your savings account will be protected up to a maximum of $250,000 as long as you keep it at a bank or credit union that the federal government insures. That ensures that your money will be safe even if the organization declares bankruptcy.

Low risk

There are various kinds of interest-earning accounts, and some require you to take on some level of risk to earn returns. You can earn returns on savings accounts without running the risk of having your money disappear.

Explaining the disadvantages of savings accounts

Fees

There is a possibility that you will reduce your earnings due to the fees that financial institutions may assess for savings accounts. For instance, a monthly fee might be assessed to your account if the balance falls below the amount required to maintain the account's minimum balance.

Reduced APYs

The returns on savings accounts are typically low because of the absence of risk. When compared to other investment vehicles that can generate interest, such as CDs, savings accounts typically offer annual percentage yields that are lower.

There are no tax benefits

The interest you receive from your savings account will be subject to taxation in the year it is paid out.

Restrictions placed on the account

There are typically a number of limitations associated with savings accounts, including minimum balance or deposit requirements, withdrawal limits, and limited methods for making deposits or withdrawals. For instance, in order to obtain a particular APY, you might be required to deposit a certain minimum amount into the account. In addition, you might only be allowed to make six withdrawals each month without incurring any fees.

The FDIC insurance only goes so far

If you intend to keep more than $250,000 in an account at any given time, any amounts that are kept in excess of $250,000 will not be covered by federal insurance.

Alternate Options for Savings Accounts

Although a savings account is often a good place to begin, other kinds of accounts may be a better fit for your needs or make a good additional account. The following are some options that you could consider instead.

Accounts on the Money Market

A money market account (MMA) is a different kind of savings account that is offered by financial institutions like banks and credit unions. In some cases, the government frequently insures these accounts for up to $200,000. The annual percentage yields (APYs) and minimum balance requirements of money market accounts (MMAs) are known to be higher than those of traditional savings accounts. However, there are now high-yield savings accounts that offer rates that are higher than those offered by MMAs without the requirement of maintaining such large balances. According to an FDIC report published in January 2022, the average annual percentage yield (APY) for money market accounts is roughly equivalent to the average APY for conventional savings accounts.

Deposits in the form of Certificates

A certificate of deposit, also known as a CD, is a special kind of savings account that allows you to earn an annual percentage yield (APY) on the principal amount you keep in the account for a predetermined period. For instance, if you wanted to earn the interest on a certificate of deposit that was for 12 months and had an annual percentage yield of 0.14%, you would have to keep the money in the account for the full year. In most cases, the annual percentage yield (APY) will be higher if the term is extended. However, if you withdraw your money before the specified time, you will typically be required to pay the penalty for early withdrawal or forfeit any interest earnings that have accrued. Compared to savings accounts, longer CDs may offer higher returns. However, to receive the full benefit of those returns, you will be required to keep the money in the account for a predetermined period.

Low-Risk Bonds

Putting your money into Treasury or municipal bonds is a riskier investment than keeping it in a savings account. However, due to the fact that the government backs these bonds, it is still a relatively safe investment compared to investing in other types of bonds. Additionally, the returns may be superior to those offered by a savings account. Treasury bonds typically have maturities of either 20 or 30 years and pay a fixed interest rate on a semiannual basis up until the time they are redeemed. You can get these by shopping on the United States Treasury Department website or by visiting a bank, broker, or dealer in the United States. You are able to lend money to the issuer of municipal bonds in exchange for regular interest payments. Municipal bonds are issued to finance a city, county, or state government's daily obligations or capital projects. The duration of the bond determines the date that the bond is scheduled to mature; short-term bonds typically mature within one to three years, whereas long-term bonds typically don't mature for more than ten years. The interest rates offered on municipal bonds are subject to change; however, they typically mirror the bond market as a whole. The interest earned on municipal bonds is typically exempt from taxation at the federal level, and there is a possibility that it is also exempt from taxation at the state and local levels in the state in which you issued the bonds.

Peer-to-Peer (P2P) Lending

You will have a one-of-a-kind opportunity to earn a higher rate of return on your money if you invest it in peer-to-peer lending platforms, which are becoming increasingly popular due to their ability to match borrowers and lenders directly. These websites facilitate matching individual borrowers and individual lenders and provide accounts for investors that one can open with a minimum deposit of only $25. You will put your investment toward funding personal and business loans, and the potential returns on those loans can reach the double digits, depending on the borrower's risk profile. Although the interest rate needs to be considered in conjunction with the risk involved (since these are unsecured loans), they might be a better option than a savings account.

How to Make the Most of Your Savings Account

When you first start putting money away, opening a savings account is typically a good first step to take. It is risk-free and a good place to put money aside for unexpected expenses. If you decide that opening a savings account is the right financial move for you, you should look into the various options available to find the one that is most suitable for your circumstances. Look for a bank that has reasonable account requirements, low monthly fees, a competitive annual percentage yield, and helpful customer service. Once you have an emergency fund set up that will last you for six months, it may be beneficial to diversify your holdings. Investigate the possibility of using other vehicles for saving money that provides a higher rate of return, despite the fact that they might be a little less liquid or involve more risk. You also can allocate a different portion of your income to retirement savings, which you can place in investments that are even riskier but have the potential for a much larger gain. Stocks, bonds, and mutual funds held in tax-advantaged accounts such as a 401(k) or Roth IRA have the potential to generate current tax benefits in addition to the possibility of larger distributions in the future. If you have some time on your side, these investments can be very beneficial.

Frequently Asked Questions (FAQs)

How does the accrual of interest on a savings account work?

When you deposit money into a savings account, you are given the opportunity to earn additional money through the accumulation of interest on that money. The annual percentage yield, also known as APY, is a metric that is used by financial institutions and indicates how much money you can expect to earn annually. For every $100 you leave in the account over the course of a year, for instance, you will receive a total of $1 in simple interest thanks to the account's annual percentage yield (APY). However, if an account offers compound interest, which allows you to earn interest on the interest you earned, you may earn more money from that account. The more frequently the interest is compounded, the more money you will earn.

What sets a checking account apart from a savings account? What are the pros and cons of each?

The primary distinction between checking accounts and savings accounts is that checking accounts are intended for more frequent use. In contrast, savings accounts are intended for money that you do not intend to spend in the near future. However, there are several other differences between checking and savings accounts. Since the pandemic started, the federal law that limited savings accounts to six withdrawals per month have been put on hold. This restriction was in place before the year 2020. One more distinction is that checking accounts typically do not offer you the opportunity to earn interest on the balance of the account, whereas savings accounts typically do.

How much cash should I always sit in my savings account?

If you want to figure out how much money you should save, a good rule is to aim at least enough to cover your living expenses for three to six months. You should save more money if you have a high income or if it takes you a long time to find a new job in the event that you lose your current one. If anything unexpected occurs that prevents you from earning money, having an emergency fund with this much money saved up can help ensure that you have a safety net to fall back on. Beyond that, it is to your advantage to put as much money as possible toward other objectives, such as purchasing a home or retiring comfortably. Check your budget regularly to see how much you can put away after paying for what you require.

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