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  • Writer's picturePatrick Aloisio

How Savings Accounts Work

Updated: Jul 20, 2022


how savings accounts work

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You give the bank your money to hold onto and keep safe.


In exchange for you giving your money to the bank, the bank says "thank you" by paying you a percentage on your money each month. But what's in it for the bank? Why would they do this?


Well, how the bank makes their money is by loaning your money out to other people. In essence, they are doing an arbitrage with the difference of the two interest rates. They pay you 1% on your money so they can loan it to other people for 2% and keep the difference.


There are laws in place that limit the amount of money the bank can lend out. This amount is called the "Reserve Requirement."


If a bank holds $100 million worth of people's money and the Reserve Requirement is 10% then they must hold at least $10 million at all times, and can loan out the other $90 million.


The banks can run into issues if the loans end up defaulting, or if some event causes the customers of the bank to try and withdraw more than the bank keeps in their reserves. This is called a "Bank Run."


The higher the Reserve Requirement, the safer it is for the customers to hold their money with that bank.


What are the pros and cons of this set-up for customers?


Pros:

  • Super safe for customers - Your money is backed with a guarantee by the FDIC. (Up to $250,000)

  • Guaranteed positive returns - You know the value won't drop below the amount you put in like it might with stocks.

  • Liquid & Accessible - The cash doesn't have to be converted or sold like real estate or stocks would.

  • Easy set-up - You can set up an account at a bank within an hour.

Cons:

  • Restrictions on withdrawals - There might be penalties or fees for withdrawing too frequently.

  • Very low rates - Right now the interest on a savings account is basically zero.

  • Rates not fixed - The banks might say a higher interest percentage but they can always reduce them in the future.

  • Minimum balance requirements - If you had to withdraw an amount for an emergency that goes under the bank's minimum threshold, you might have to pay a fee, or close the account.

how savings accounts work

Make sure you understand the pros and cons of traditional savings accounts when evaluating where to keep your money.


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