How do savings accounts work?

The most common type of bank account, and probably the first account you'll ever have (after a checking account), is a savings account. Savings accounts allow you to keep your money in a safe place while it earns a small amount of interest each month. These accounts usually require either a low minimum balance, like $25, or may require no minimum balance at all. This depends on the bank and the type of account.

Besides the fact that you will be less likely to spend it, putting your money in a savings account is safer because it is insured. If your home is robbed or burns down, your money may be lost forever. Banks and credit unions, on the other hand, keep your money in a locked and fireproof safe. Banks insure your money (up to $100,000) through the Federal Deposit Insurance Corporation (FDIC). This means that even if the bank goes out of business (which is very rare!) your money will still be there. (The National Credit Union Administration (NCUA) insures credit union accounts up to $250,000.) The FDIC is an independent agency of the federal government that was created in 1933 because thousands of banks had failed in the 1920s and early 1930s. Not a single person has lost money in a bank or credit union that was insured by the FDIC since it began. When you put your money into a savings account, it earns interest. Interest is money the bank pays you so that they can use your money to fund loans for other people. That doesn't mean you can't have your money whenever you want it, though. That's just how banks make money -- by selling money! Basically, it works like this:

You open a savings account at the bank.
The bank pays you interest on the money that you deposit and leave in that account.
The bank then loans that money out to other people, only they charge a slightly higher interest rate on the loan than what they pay you for your account.

The difference in interest they pay you verses the interest they charge others is part of how they stay in business.

Interest on savings accounts is usually compounded daily and paid monthly. The cool thing about compounded interest is that the bank is paying you interest on the money they've paid you in interest! That means that if your account earns one percent interest, then each day 1/365th of that one percent of the amount of money you have in your savings account is then added to your total. Here is the calculation:

Daily compounding = Principal (1 + interest rate/365)365 = (daily compounded amount)

On the next page, we'll explore how banks and credit unions manage savings accounts and explain what happens when you open your new account.

Types of Savings Accounts

Financial Institutions and Savings Accounts

The amount of interest your money earns in a savings account often depends on the type of financial institution you have selected and the type of account. Banks and credit unions are different animals. While banks are commercial businesses, credit unions are typically non-profit cooperative organizations that are organized for specific groups of people. For example, state employees usually have access to a State Employees Credit Union. Typically, loans are less expensive at credit unions, but interest rates may not always be as high as what you can get at a bank. This isn't always the case, though. Currently, some credit union interest rates are higher than what you will find at some banks. Sometimes credit unions also pay interest on accounts that banks usually don't pay interest on, like checking accounts. But, you have to be a member in order to open an account.

Banks usually offer two types of savings accounts: a basic savings account, and a money market account.

The basic savings account (sometimes called a passbook savings account) will usually have either no minimum balance requirement or a low one, but will offer a very low interest rate (meaning your money won't earn that much). In April 2004, the average interest rate at banks for basic savings accounts was less than one percent. A typical basic savings account lets you withdraw your money whenever you want.
Money Market accounts usually pay more money in interest, but will typically require you to have more money in the account. You also may be limited to how many withdrawals you can make in a month. Sometimes, in addition to the withdrawals, you can also write up to the three checks on a money market account each month.

Costs Involved

Sometimes, but not always, banks charge fees for having a savings account. The fee may be low -- like a dollar a month -- or it may be higher or it could even be based on your balance. For this reason, you should always shop around and compare what different banks are offering. Things you should look at include:

Fees and services charges on the account
Minimum balance requirements (Some banks charge a fee only if you don't keep a certain amount of money in your account at all times.)
Interest rate paid on your balance

What happens once you have a savings account?

When you open a savings account you'll get a small book called a register (like a checkbook register) where you write your beginning balance (the amount you originally deposit) and all of your future deposits and withdrawals. This tool helps you keep track of how much money you have.

Each month, your bank (or credit union) will send you a statement of your account either in the mail or by e-mail if you prefer. The statement will list all of your transactions as well as any fees charged to your account and interest your money has earned. In order to make sure you didn't forget to write down any withdrawals and/or deposits (and also to double-check the bank's activities) you should go through each entry in your register and compare it with the bank's statement. They should match up -- this is referred to as reconciling your account. If they don't, you'll need to find your mistake and correct it in your register (unless it is a bank error, but that isn't very common).

The only other thing is to remember to make deposits into your account and sit back and watch your money grow! For more personal finance and savings information, check out the links on the next page.