Everything I read assumes I already know so much! What kind of savings accounts should I use and for what? It seems like people are stashing money all over the place. – Reader (Permission to use name emphatically denied.)
I recently received an email with this reader question. They were glad to have the question shared but did not want to be identified. I understand. It’s easy to feel embarrassed about not knowing something you believe everyone else knows. Let me assure you that far fewer people than you’d expect actually know this information. We can change that together.
Today’s post will explore the question about savings accounts, but let me digress briefly to explain my approach to these questions for my regular readers. (feel free to skip ahead to the savings account content!)
One of the best surprises about starting this blog has been how quickly I started getting questions from readers. It reinforced my belief that although there are lots of personal finance blogs out there, there are still many people who we haven’t yet reached.
The questions also repeatedly remind me that people are accessing content at a variety of different places A direct reminder led me to create the FI Primer and follow-up series. Topics that seem common or over-written to others in the PF space are still quite new to many.
As I’ve gotten these questions, I’ve tried to determine how to best answer them. I want PrincipalFI.com to be a comprehensive resource, but also want to amplify and recognize other great work. Of course, I’m just sharing my personal perspective and experience and not speaking as a certified financial expert.
Therefore, I’ve decided that when I receive questions which I can answer by sharing my own approach, I will do so and link to other resources where relevant. For topics with which I have no personal experience, I’ll write a resource post pointing to specific posts that I (or others) have found particularly useful. I hope this approach is valuable without becoming redundant with other content out there.
I’m traveling for a bit, so it seemed like a good time to try both these approaches. In today’s post, I’ll talk about savings accounts and how I use them. Next week, I’ll share a resource post about 529s. I hope these are useful!
And now…back to today’s actual post…
“What Savings Accounts Should I Use and For What?”
At the start of this post, I shared the reader’s question. It’s a great one. Savings is an important part of managing your financial life. It’s important to remember that savings accounts won’t typically accelerate your wealth accumulation but they are an important part of a financial strategy.
Related Post: Strategic Savings: How to Create, Secure, and Deploy
Let’s do a quick review of types of savings vehicles and then I’ll share how we personally use each.
Savings Account Types:
- Money Market Accounts
- Other Savings vehicles
Three Common Uses:
- Emergency Fund
- Targeted/Sinking Fund
Overview of Savings Account Types
A traditional savings account is held at a traditional bank with a physical location. This is what most people think of when hearing the term “savings account.” Picture walking into a bank, signing some forms, and opening an account. You might even have a deposit book – very traditional!
The pros of a traditional savings account are ease of access and the ability to link to a checking account for overdraft protection. You can go to a physical location or use an ATM to access your money as well as make online transfers between accounts.
The significant downside of a traditional account is that they pay little to no interest. Money held in a traditional savings account is losing purchasing power rapidly due to inflation. Because of this, you do not want to keep large sums in a traditional savings account. It’s “safe”, but you are losing money.
Online accounts are offered by banks that often don’t have a physical location. For a variety of reasons, many of these banks pay higher interest rates. As the name implies, the set-up and management of this account is done entirely online.
The major benefit of an online account is the higher interest rate. Currently, major online banks are paying over 2% for online savings accounts. This helps your money retain it’s purchasing power. Note that even these rates typically aren’t higher than inflation – your money is still losing purchasing power, just not as quickly.
The downside of an online account is that it can be harder to access your money. You are typically limited to six transfers/withdrawals per monthly period and may be charged a fee or have your request denied for transfers over the limit. (This is also true of a traditional account, but you can access an ATM or physical bank location to avoid these limits.)
Money Market Accounts
A money market account is best thought of as a hybrid between a savings account and a (limited) checking account. It typically requires a higher minimum balance to open and maintain to avoid fees. A money-market account is FDIC insured up to $100,000.
The pros are the higher interest rate and ability to write checks from the account. Be aware – your number of transactions is still limited and fees may apply.
Prior to the growth of online savings accounts, money-market accounts were the best way to get reasonable interest rates. If you perform a limited number of transactions, this could also entirely replace your checking account.
Other Savings Vehicles You May Read About (Which we aren’t currently using):
Certificates of Deposit (CD): With a certificate of deposit, you commit your savings for a fixed period of time in exchange for a higher rate of return. The longer you commit your money, the higher the rate. As an example, using Bankrate at the time of writing: Capital One rates are currently 2.7% for a 1year CD and 3.1% for a 5 year CD.
There are strategies (such as a CD ladder) you can use to protect the purchasing power of your money if you are holding substantial cash. We are not, so are not currently using CDs.
Money Market Funds: A money-market fund is a mutual fund that invests in debt-based securities with low risk. They strive to maintain a stable value and can provide higher returns than other options. A money market fund is not insured by the FDIC. Some consider these as safe as a traditional savings account, but this is not technically true.
If you are keeping larger amounts of cash, a money market fund may be worth the (slight) additional risk. We are in the accumulation phase, so our cash savings are held in savings accounts and everything else is placed into investments.
How We Use Savings Accounts
As I’ve noted, we are currently in the accumulation phase of our financial independence plan. That means the vast majority of extra money we save goes straight to investments. However, we do maintain about 5 months of cash and there are times where this goes higher.
We strive to maintain a balance between optimization and simplicity. This is not optimal, and may not meet your needs, but I find it helpful to read examples so I’m happy to share ours.
Short term liquidity
One reason for holding cash is simple liquidity. You need to be able to manage your monthly expenses, pay your bills on time, and avoid overdrafts. Some use just a standard checking account to hold this money. We prefer a separate savings account attached to our checking account – do what works for you.
What We Do
We maintain a checking account at a local credit union for our direct deposits and auto-payments. We have a traditional savings account and hold one month worth of expenses in savings here for liquidity purposes. This allows us to pay off any bills immediately and never worry about accidental overdrafts or transfers. The two accounts have low minimum balance requirements and fee structures. We also get a small interest rate benefit on our mortgage loan by holding this account.
An additional benefit of holding one month’s expenses in this account: we do not need to be concerned about variable bills like our 6-month insurance payment or fluctuating utility bills. We simply pay from this account and then rebuild in the next month.
We are giving up a (very) small amount of interest by having a months worth of expenses here instead of an online account or money market, but the flexibility and simplicity work for us.
You should have an emergency fund that you do not access except for emergency purposes. This amount is large enough that you want to guard against inflation and earn the largest safe interest rate possible. An online savings account is perfect for this.
We hold an online account with Discover Bank for our emergency fund. We chose this because of a competitive interest rate combined with an offer of $150 for opening the account with $15,000 or more. Currently, the interest rate of 2.1% is lagging behind others like Ally.
You can check the latest rates at Bankrate. Ensure you do your research about bank quality before picking solely on a rate. We chose Discover because it was an established bank and has a high-quality app that makes managing and moving money simple. (Note: I am not a Discover affiliate.)
What We Do
We maintain 4 months worth of expenses in this account for our emergency fund. You will read a variety of recommendations for the size of your emergency fund. The most common is 3-6 months worth of expenses. We were originally planning to accumulate 6 months, but have decided that having 4 months here, and an additional month for liquidity is sufficient for us.
Finally, another use of savings accounts is to plan for larger expenses rather than buying on credit. These are typically referred to as sinking funds or targeted savings accounts. You contribute to these on a monthly basis to pay long-term anticipated expenses or large future purchases.
Sinking fund examples include house maintenance funds, car purchases, large vacations. You should not buy these on credit, but instead, save until you can afford them.
What We Do:
For the smaller sinking fund type expenses (think six-month car insurance payments) we just use the traditional savings account to let it wash out. Others choose to keep a dedicated account for this.
However, when we identify a large anticipated expense, we will use an online savings account for a sinking fund. We keep this separate from our emergency fund and sign-up based on rate or bonus.
Examples: We are about to begin saving for a
We would also do the same if we were planning on purchasing a car. (We aren’t currently.) That would be another targeted fund that we’d likely build up with deposits over a period of months or years.
SUMMARY Of Our Savings Account Usage
|Purpose||Liquidity||Emergency Fund||Small Sinking |
|Large Sinking |
|Account Type:||Traditional Savings||Online Savings||Traditional Savings||Online Savings|
|Amount||1 month expenses||4 months expenses||< $1000||> $1000|
|Current Rate||.05%||2.1%||.05%||>2.2% (TBD)|
What You Should Do
- Plan out your savings strategy
- Decide how much money you need for liquidity
- Set a target for your emergency fund
- Identify targeted savings needs
- Choose the account type that works for you for each purpose
- Research for best rates and other criteria important to you
Please do not hold large amounts of cash in accounts earning little to no interest. You are actually losing purchasing power due to inflation. If you have a large amount of cash in a traditional savings account, choose an online account at the very least. Even if this is the only thing you take from this article, it’s worth it!
Here is a recent experience with choosing and opening an online savings account from Dave at Accidental Fire.
Women Who Money also just ran two great posts related to this topic:
Please let me know if you find other useful resources to share with our community.