If you’re saving money for short-term goals like taking a vacation or building up an emergency fund, it’s important to have easy access to that money. But just because you aren’t investing that cash doesn’t mean you can’t earn high interest on it.
Enter high-yield savings accounts. These accounts offer higher interest rates on savings than accounts at many traditional banks. But before you open one, it’s important to understand how they work, as well as their pros and cons.
What are high-yield savings accounts?
High-yield savings accounts are savings accounts that usually reward savers with a higher rate of interest than traditional savings accounts.
It’s important to keep in mind that interest rates on savings accounts are variable, meaning that banks can change the rates as they see fit. For example, just because you sign up for a high-yield savings account when it’s offering a 4.50% annual percentage yield (APY) doesn’t mean that you’ll earn that rate forever. Some accounts also require a certain minimum balance to be met to get a certain rate.
However, even when high-yield savings account rates go down, they typically still offer more than traditional savings accounts. Like regular savings accounts, high-yield savings accounts at banks protected by the Federal Deposit Insurance Corp. (FDIC) insure bank deposits up to $250,000 per depositor. That means if the bank suddenly collapses, you won’t lose your money.
Differences between regular and high-yield savings accounts
While the national average rate for regular savings accounts is a mere 0.46% as of December 20, 2023, many high-yield savings rates are offering APYs of around 5.00%. That means that money stashed in high-yield savings accounts grows at a faster rate than money in traditional savings accounts.
High-yield savings accounts are often offered through online banks, such as Ally and SoFi. Because of that, they may not come with all the same banking services as traditional banks, including the ability to visit physical branches and get in-person help or write checks. You may also not have as many withdrawal options.
It’s important to look into exactly what services you can get with a high-yield savings account to ensure it’s the best fit for you.
How high-yield savings accounts work
Like with all savings accounts, interest on high-yield savings accounts is a bank’s way of rewarding savers for keeping their money with that bank. The amount of money you’ll get back just for parking your cash with the bank is determined by your balance, the interest rate and how often that rate is compounded.
Compound interest is the interest that you’ll earn both on the amount of money you have in the account (the principal) and on accumulated interest — in other words, interest on interest. Compound interest enables your money to grow much faster than simple interest, which is interest only on the principal amount.
Savings accounts don’t all calculate that compound interest at the same time; some may calculate it daily, while others do so monthly, for example. This will determine how often and when you’ll see interest payments deposited into your account. The more frequently interest is compounded, the more money you’ll make.
Pros and cons of high-yield savings accounts
Before you open an account, it’s important to be aware of the benefits and downsides of high-yield savings accounts.
Pros of high-yield savings accounts
High-yield savings accounts come with higher APYs than traditional savings accounts, which means your money is working more for you.
“High-yield savings are a great spot for dollars that you’re not ready to commit for longer-term investing or retirement savings,” said Kyle Akers, a senior advisor at Modern Wealth Management.
These accounts are liquid, meaning you can easily withdraw your money. They usually allow for easy transfers to other accounts and are simple to manage online.
Cons of high-yield savings accounts
The frequency of withdrawals can be restricted with high-yield savings accounts, Akers said. For example, Ally’s Savings Account limits you to 10 transactions per statement cycle. There’s no fee for going over the limit, but Ally may close your account if you exceed it often.
He added that you may also have to have a minimum specified amount of money in the account to receive certain interest.
The rates on high-yield savings accounts are also variable and can change at any time. And while these accounts offer more interest than traditional savings accounts, they won’t grow your money in the same way investing in stocks, bonds and other securities might. That’s why financial advisors tend to recommend only keeping enough in your savings accounts for short-term needs and investing money that’s intended for long-term goals.
How to choose the right high-yield savings account
You’ll want to do careful research before choosing a high-yield savings account. While these accounts almost always come with the benefit of a high APY, they’re often associated with online banks, which means that they may have limited services compared with traditional banks.
Ideally, you want an account with high APYs and low fees. While some high-yield savings accounts don’t have fees, others will charge monthly maintenance fees, or charge fees but waive them if you maintain a certain balance. You’ll also want to determine whether or not an account has an initial deposit minimum or a minimum balance you need to maintain to ensure you receive the advertised APY.
While you’ll likely be on the lookout for the highest yield, Akers said to ensure the institution also makes your money easily accessible when you need it. Keep in mind that not all online banks have dedicated ATMs or ATM cards.
You’ll also want to ensure that the bank you open an account with is protected by the FDIC. Use the FDIC’s BankFind tool to check if a bank is insured.
Factors influencing the interest rates of high-yield savings accounts
Interest rates on savings accounts fluctuate. Typically, a bank will increase the interest rate when it wants more cash deposits and needs to attract customers.
The largest factor that impacts how a bank changes its interest rates is the federal funds rate, which is determined by the Federal Reserve and has a trickle-down effect on the cost of everything from mortgages to credit card debt. During economic downturns, the Fed tends to lower the federal funds rate to encourage consumers to borrow and spend money, which can help stimulate the economy. But when the economy is booming, the Fed will often do the opposite: It will hike interest rates in an attempt to cool the economy.
Because banks often mirror the Fed’s moves, interest rates on savings accounts change with the direction of the economy.
Tax implications of high-yield savings accounts
Like a regular savings account, you have to pay taxes on the interest you earn in your high-yield savings account. If you receive $10 or more in interest, your bank is required to send you a 1099 form that reports the payments of interest — though you have to make sure to pay taxes even if you don’t receive this form.
The interest you earn is considered taxable income, and your taxable income determines your tax bracket.
Are high-yield savings accounts risky?
High-yield savings accounts have no market or price risk, said Chuck Etzweiler, senior vice president of research at Nepsis, a financial planning and investment management firm. This means putting money into these accounts is not like investing in the stock market, which entails the risk of losing the amount you invest. Savings accounts are protected by FDIC (as long as the bank is FDIC-insured), which means your money is protected up to $250,000 per depositor, per FDIC-insured bank, per ownership category.
“However, they do have reinvestment risk in that when rates drop the interest received on these accounts drops as well,” Etzweiler said. “Many times, savings accounts earn less than the rate of inflation, so on a real basis investors are receiving a negative rate of return.”