For many people, savings accounts are the first financial products they ever use. Beyond the simple convenience they offer as a place to safely store your money, savings accounts are powerful tools for growing your money in a safe and reliable way.
Introduction to Savings Accounts
Whether you are new to having a savings account or never really understood their real potential, the first step to taking full advantage of this important financial tool is understanding what it is and how it works.
What Is a Savings Account?
A savings account is a type of bank account designed specifically to help people set aside money. As incentive to keep that money in the account, the funds earn interest over time. Users grow their savings accounts based on a modest interest rate offered by banks, which means that the banks pay a small percentage of the balance to the account owner regularly.
Basic Functionality of Savings Accounts
The main purpose of a savings account is to encourage people to save money by limiting easy access to their funds and offering interest. This is in stark contrast to checking accounts, which are primarily for conducting daily transactions and bill payments and generally do not pay any amount of interest or offer an opportunity to grow your money.
Understanding How Interest Works
The main appeal of using savings accounts to grow your money is the ease and security these accounts offer as compared to other financial investment options. Because of the modest, fixed interest rates associated with savings accounts, they represent a secure, low-risk way to grow your money.
The Concept of Interest in Banking
In the simplest terms, interest is the amount of money a bank pays you for keeping your money in an account. In other words, it’s the bank’s way of rewarding you for letting them use your deposited funds to offer other consumers loans and other banking services.
How Interest Is Calculated on Savings Accounts
Banks calculate interest periodically, according to a set time that is embedded into the account’s terms. Most interest rates are advertised based on their annual percentage yield (APY). APY represents how much interest you can expect to earn each year, expressed as a percentage. What that adds up to in real dollars depends on the type of interest offered on the account: simple vs. compound interest.
Simple Interest
Simple interest is calculated based only on the principal, or the amount of money deposited into an account.
To calculate simple interest, use the formula A = P x R x T where
- A = the amount of money in your account after interest is paid
- P = the principal amount deposited in the account
- R = the yearly interest rate, expressed as a decimal
- T = time, expressed in years or parts of years (1 month = 0.083 years)
Compound Interest
Calculating compound interest is a bit more complex because banks calculate it based on both the principal as well as any interest paid on the account. What makes things even more complex is that compounding can be applied at different intervals, such as daily, monthly, or annually, again depending on the terms of the account.
The formula for calculating compound interest is A = P(1 + R/N)NT where
- A = the amount of money in your account after interest is paid
- P = the principal amount deposited in the account
- R = the yearly interest rate, expressed as a decimal
- N = the number of times the bank compounds interest over the course of a year
- T = time, expressed in years or parts of years (1 month = 0.083 years)
Factors Influencing Interest Rates
When customers open savings accounts, the bank will offer an interest rate that helps them predict how much they can grow their money. However, savings account interest rates vary, and it’s important to be aware of various factors.
Economic Indicators and Their Impact
The first set of factors that influence interest rates come from the economy at large. The decisions made by the U.S. government, for example, can drive interest rates up or down. In fact, one of the primary drivers of interest rate changes is the Federal Reserve (or central banks in other countries), which sets the federal funds rate as a benchmark.
When the economy is strong and inflation is rising, the Fed may increase interest rates to make borrowing more expensive, slow down spending, and encourage people to save. Conversely, during periods of low inflation or recession, the Fed may lower interest rates to make credit more accessible and to encourage investment and spending rather than saving.
Bank-Specific Factors
Apart from broader economic conditions, individual banks have their own factors that can affect the interest rates they offer on savings accounts. Competition among banks, for example, is a significant bank-specific factor that can drive the interest rates offered to customers. Specifically, when one bank raises its savings account interest rates to attract more customers, others may follow suit to remain competitive.
Choosing the Right Savings Account
The trick to using savings accounts to effectively grow your money lies in pairing the right savings account with your financial profile. Before making that first deposit, take some time to consider the options.
Types of Savings Accounts
Broadly speaking, many different types of accounts can qualify as “savings,” including money market accounts and certificates of deposit. However, these represent more complex financial products that come with stricter restrictions. That said, there are still a few important types of simple savings accounts to consider.
Traditional Savings Accounts
Traditional savings accounts are what most people think of when they hear this term. Usually attached to a checking account, these types of savings accounts are the most flexible. They have low minimum deposits and very few restrictions. However, they also often offer the lowest interest rates.
High-Yield Savings Accounts
As the name implies, high-yield savings accounts are designed to make customers more money, but they require a larger investment. These savings accounts are often more restrictive, such as having a maximum number of withdrawals allowed each month and requiring customers to put down a high principal investment to take advantage of that growth.
Specialty Savings Accounts
Operating somewhere in between, specialty savings accounts usually have some additional requirements beyond the traditional savings, but not as many as the high-yield accounts. Specialty accounts include youth savings accounts, custodial savings accounts, and student savings accounts that cater to a very specific demographic.
Comparing Account Features and Benefits
As you learn more about the different types of savings accounts in general as well as what types your financial institution offers, it’s important to take time to compare their specific features and match them to your lifestyle and savings goals. If you have a large amount of money for a principal deposit, for example, a high-yield savings account may be your best option. On the flip side, opening a youth or teen savings account for your child offers them a number of benefits now and in the future that are worth considering.
Reading the Fine Print: Fees and Limitations
Finally, before committing to a savings account — or any financial product — make sure to take the time to speak with your financial advisor or a specialist at your financial institution about the fine print surrounding any limitations of the account. Ask specific questions to make sure you understand what you are getting with a specific account. For example, what happens if your balance goes below the minimum? Are there any yearly fees for the account? How do you transfer a youth savings account to an adult account when the time comes?
Choose HRCCU to Open Your Savings Account
If you are ready to open up a new savings account, let Hudson River Community Credit Union (HRCCU) help. We offer several different savings options alongside personal and professional advice that can help you ensure that you get the account you need for your lifestyles and goals. Contact us or stop by one of our branches today to learn more.
