When you have money you want to stash away for emergencies or to reach a financial goal, conventional wisdom usually recommends opening a high-yield savings account. When I was faced with the question of what to do with $1,000 of extra cash this year, I struggled with this rule of thumb.
The Federal Deposit Insurance Corporation reported a .06%* national average rate on savings account interest in the U.S. as of July 27, 2020. Money market accounts, which typically offer a slightly higher interest rate, currently have a .08%* APY, according to the FDIC. Online banks usually offer much higher interest rates than traditional banks, as they have less overhead to fund; some even point out their interest rates in their marketing. But when you look at the top-earning online savings accounts for July 2020 at the best banks, the highest annual percentage yield is only 1.11%*.
Low numbers like these caused me to wonder whether keeping extra money, especially a small amount, in a high-yield savings account is really worth doing. If you’re thinking the same thing, here is a look at what these accounts are good for and when you should think about putting your money elsewhere.
How do high-yield savings accounts work?
High-yield savings accounts are named because they offer relatively high APYs compared to traditional savings accounts. An APY is used to calculate the rate of interest your savings balance will earn over the course of a year. Does that mean after a year you’ll have earned $10 if you open a high-yield account with $1,000 and an APY of 1%? Not quite.
High-yield savings accounts compound interest, usually daily, monthly, quarterly, or annually. This means that a portion of the APY is applied toward the account’s balance at a specific time. If your account compounds interest annually, you would earn $10 in the example above because the full APY is applied to your original balance.
When you have a savings account that compounds more often, the interest earned up to that point is added to your balance. The next time the interest is compounded, the amount you earn will be calculated based on your original balance, plus the amount that was previously added to the account.
Let’s see how this works using the numbers above. Your savings account compounds interest quarterly. Because the APY is 1%, each time interest is compounded, a rate of .25% (1% divided by each compounding period) is applied to your balance for each quarter.
- Three months after your $1,000 initial deposit, you’ll add $2.50 to your account balance: .0025 x $1,000 = $2.50 and $1,000 + $2.50 = $1,002.50.
- After the next three months, interest will be compounded again at a rate of .25% on a balance of $1,002.50 for a total of $2.51 (rounded up) added: .0025 x $1,002.50 = $2.51 and $1,002.50 + $2.51 = $1,005.01.
- At the next quarter, the interest will be compounded on a balance of $1,005.01 and will add another $2.51 to the account: .0025 x $1,005.01 = $2.51 and $1,005.01 + $2.51 = $1,007.52.
- The final time your balance is compounded, it will be $1,007.52 and $2.52 will be added for a grand total of $1,010.04: .0025 x $1,007.52 = $2.52 and $1,007.52 + $2.52 = $1,010.04.
With compounding added quarterly to this high-yield savings account, you would earn $10.04 in interest instead of $10 when compounded annually. The more frequently an account compounds interest, the more you earn.
Because the national rate for savings APY is at .06%*, a 1% rate is high and most likely to be offered by an online bank. Some online banks are anywhere between .10% and 1.11%*, which makes them the best savings accounts for earning interest.
Are high-yield savings accounts worth it?
After looking at the current rates and how they could apply to the $1,000 I wanted to set aside, I was not too excited at the prospect of opening a high-yield savings account. Adding around $11 to my account did not seem like very much. Yes, passive income is always a good thing, but I wanted to get the most out of where I chose to stash my cash. So I asked some experts what they think about high-yield savings accounts.
Adam Beaty, a certified financial planner at Bullogic Wealth Management is a big fan of high-yield savings accounts, uses them personally, and recommends them to clients. He says they are a good choice for creating an emergency fund. “We recommend putting three to six months worth of non-discretionary expenses in a high-yield savings account,” Beaty says.
Beaty advises that high-yield savings accounts are not where you want to put your money if you’re looking to save for retirement or build wealth. They’re more for saving toward a goal, such as a vacation or wedding, or having cash you can (relatively) easily access when something unexpected happens, like unemployment or home repair.
Daniel Patterson, a certified financial planner with Sweetgrass Financial Planning, agrees and suggests looking into other financial products when deciding what to do with money that isn’t for short-term use.
“Any money that is in excess of what you need to stay in your emergency fund or money being set aside for some short-term goal should be invested in low-cost mutual funds and [exchange-traded funds], as high-yield savings accounts are not where you should park your long-term investment money,” he says.
3 alternatives to high-yield savings accounts
If it sounds like a high-yield savings account might not fit what you have in mind for your money, there are some alternatives that can offer higher rates of growth if you commit to keeping your money there for some time. See whether any of these options would work for your situation.
- Certificates of deposit
- Mutual fund
1. Certificates of deposit
A certificate of deposit, or CD, is a special type of account in which you commit to store your money for a set period of time. You’ll earn interest at an APY that is often higher than what banks offer for high-yield savings accounts. Interest can be fixed or compounded. If you’re shopping around for rates, see whether they’re fixed (no compounding) or have an APY and how often the interest is compounded.
CDs are low-risk investments, as you’re essentially keeping your money in a bank account for a certain time frame. If you open a CD with an FDIC-insured bank, up to $250,000 of your account is insured by the federal government.
When you invest in stocks, you’re using your money to purchase a small portion of a company through a publicly traded market. Stocks are traded in shares and each share is set at a price. Those prices continually go up and down as shares are traded. But if you invest your money in a stock that increases in value, you can make money because your shares are worth more than what you initially paid.
Companies that offer shares in the stock market may also pay dividends. This is a portion of the company’s earnings that is shared among all the stockholders. Usually, the amount of the dividend is set at a specific price per share. If you have 100 shares of a stock that pays 50 cents per share in dividends annually, you would get an additional $50, usually offered in cash or to purchase more shares.
Keeping your money in the stock market can be risky in the short-term, as stock prices can fluctuate drastically from day to day and month to month. Stocks are worth looking into for long-term growth. Between dividends and the growth of a stock’s value over decades, your initial investment could be multiplied exponentially. If you’re interested in this option, check out our picks for the best investment apps.
3. Mutual fund
A mutual fund is another investment product. Instead of picking and choosing stocks to buy, your money is combined with that of other investors and then put toward a collection of stocks, bonds, and other securities. A portfolio manager usually oversees the account and makes decisions about what’s bought and sold based on market knowledge and experience. The goal is to enable investors to benefit financially from a portfolio of investments they may not have been able to build by themselves.
There is always risk when you’re placing your money into the open market. However, there are many types of mutual funds and they all have different minimum investment amounts, levels of risk, and can be a more accessible way to start investing. Plus, having a finance professional overseeing your trades and investments could result in higher earnings than managing things on your own.
FAQs about high-yield savings accounts
How much should I keep in a high-yield savings account?
Our experts recommend using a high-yield savings account to build an emergency fund. Usually, you want to aim for a balance that is enough to cover your living expenses for three to six months. Keep in mind that some of these accounts may come with minimum deposit or minimum balance requirements. If you’re saving up for a specific or short-term purpose, then keep building up the account until you’ve reached your goal.
How much interest will I get on $1,000 in a savings account?
That all depends on the APY applied to the account and how often interest is compounded. The higher the APY and the more often interest is compounded, the more you’ll earn. Savings account rates vary from bank to bank. Brick-and-mortar banks may offer a lower APY than online banks, but be sure to do your research and read the fine print if you're thinking about opening a new account.
Do you pay taxes on a high-yield savings account?
You do pay taxes on a high-yield savings account, but only on the interest you earn. You’ll get a 1099-INT form from the bank that shows how much interest you have earned that year. The amount is added to your total income when you file your taxes.
What are the best high-yield savings accounts?
The top high-yield savings accounts offer generous APYs and other convenient features that make banking simple. If you’re interested in earning more interest than your current bank is offering, check out our picks for the best savings accounts.
The bottom line
I was looking for how to get the most out of committing $1,000 to some kind of financial product that would earn money. After reviewing the options, I decided to invest my money in stocks and commit to a long-term strategy where I invest a set amount monthly and hold onto my shares for the next few decades. The $1,000 was a good start and it looks like I’m on track to earn about 4% in dividends alone this year, which is more than all the other options I researched.
I also know that high-yield savings accounts are good for some purposes. If I was looking to build an emergency fund, I would choose the best savings account with the highest APY and keep making deposits until I have enough money for my needs. I would do the same if I was saving for something specific. But for right now, I’m banking on the stock market to achieve my savings goals.
Disclaimer: All rates and fees are accurate as of July 27, 2020.