“Hi Laura, this is Amy from Alaska, and I’m considering an online bank to open a savings account with higher interest rates than I’m currently getting at my local bank. Can you provide some pros and cons and tips for choosing an online bank?”
Thanks for your question, Amy! I love that you’re thinking about making your money work harder for you. In this article, I’ll review what you should know about using a high-yield savings account (HYSA), including tips for choosing the best one and how to get the most from an online bank.
What is a high-yield savings account (HYSA)?
Just like its name indicates, a high-yield savings account or high-interest savings pays higher interest than traditional savings. With the Federal Reserve’s interest rate hikes over the past years, some HYSAs offer rates more than ten times the national average, which is 0.46% APY (annual percentage yield) as of early November 2023.
The highest APYs are usually offered by relatively small online banks without the high cost of maintaining physical branches. The bank’s savings can be passed to customers through higher interest rates, allowing your money to earn more.
While choosing between a high- or low-interest account may seem straightforward (who doesn’t want to earn more on their savings?), HYSAs come with pros and cons to consider.
4 Pros for high-yield savings
Let’s explore the potential benefits of putting your money in a HYSA.
Higher annual percentage yields.
A considerable advantage is earning more interest with a HYSA than with traditional savings. One of the ways you earn more is the frequency of compounding or how often interest is accrued.
For instance, annual compounding means interest is only calculated and paid once a year. Many banks offer monthly compounding, where interest gets calculated and paid monthly. But the best regular and HYSAs have daily compounding where you get paid daily.
A savings account that pays interest more frequently is better, even with the same interest rate, because you earn more. Here’s why. Let’s say your account pays 4% APY, and you deposit $10,000 at the beginning of the year. If it compounds annually, you’ll earn $400 at the end of the first year.
But if your savings account compounds monthly, which is what many mainstream banks pay, you’d earn $407.42 at the end of the year. Some regular savings and most HYSAs compound daily, paying you $408.08 at the end of the first year.
While earning an extra $0.66 ($408.08 – $407.42) for daily versus monthly compounding may not seem like a big difference, with large deposits and more extended periods, your interest adds up. Plus, many HYSAs charge no monthly fees, a bonus.
Now, let’s compare a 4% HYSA with regular savings. If you kept $10,000 in a typical account, earning the national average of 0.46% and compounding monthly, you’d earn $46.10 at the end of the first year. That’s $361.98 ($408.08 – $46.10) less than you’d earn with a HYSA that compounds daily.
Banks state their interest rates as annual percentage yield or APY, which reflects the effects of compounding. Note that the annual percentage rate or APR doesn’t include compounding. So, pay attention to an account’s APY when comparing your options.
Opening a HYSA at a bank or credit union insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) protects your funds up to a legal limit. Both insurances cover up to $250,000 per depositor per ownership category, such as individual and joint ownership.
If your traditional or HYSA institution fails and your funds are lost, FDIC or NCUA insurance automatically reimburses you, usually within a few business days. You don’t need to apply for coverage–just be sure your institution offers it.
If you have over $250,000 in savings, you can spread it among multiple insured banks or credit unions to ensure you’re always protected. Sometimes, your institution may offer coverage at higher limits if requested.
What does the FDIC do for depositors and how can you make sure your money is always protected? The Money Girl episode below explains that and compares FDIC to SIPC protection on certain investments. Listen in the player below.
Since savings accounts pay a known interest rate and most get covered by FDIC or NCUA insurance up to limits, they come with virtually zero risk. That’s different from investments, such as stocks, mutual funds, or cryptocurrency, which fluctuate in value and can lead to significant returns or losses.
But getting the safety of a savings account means even HYSAs typically pay less than many investments. In return, you can rest easy knowing your cash will be there, plus interest, when you need it. That’s why it’s essential to save, not invest, money dedicated to short-term goals, like maintaining emergency funds, taking a vacation, or buying a car in the next few years.
However, it’s not wise to save money for long-term goals like retirement because you likely won’t earn enough to outpace inflation. That could leave you short on the income you need to be comfortable throughout your lifetime.
Liquidity up to limits
Savings accounts are more liquid or accessible than certificates of deposit (CDs), which typically have a fixed term and penalties for early withdrawals. Like CDs, HYSAs pay higher interest but without the commitment of having to lock up your money for a period.
Similarly, retirement accounts, like an IRA or 401(k), are excellent places to grow your long-term nest egg but lack liquidity. That’s because you must pay a hefty 10% early withdrawal penalty if you’re younger than 59.5, plus income tax on amounts not previously taxed.
Most HYSAs allow you to access funds through online platforms, mobile apps, and debit or ATM cards. Your ability to make withdrawals and transfers anytime makes it the perfect place for emergency cash and money allocated for short-term goals.
4 Cons for high-yield savings
Now, let’s review the downsides of using a HYSA.
Variable interest rates
Savings accounts typically offer variable interest rates tied to the federal funds rate, which means APYs can move up or down at any time. While banks aren’t required to update their rates the moment the Federal Reserve changes interest rates, most eventually adjust them.
Also, some HYSAs offer sign-up bonuses or higher rates for new customers that may decrease after a promotional period. Some of the highest rates may only apply to tiers of deposits, such as amounts over $5,000 or $10,000, with lower balances qualifying for a lower rate.
In addition, HYSAs may require you to maintain a balance or make a certain number of monthly deposits to qualify for top rates. So be sure you understand the terms you must meet to keep an enticing APY.
Another downside of HYSAs is that if they have a minimum balance, you’ll get charged a monthly fee if you don’t reach it. While most high-interest accounts don’t charge excessive fees, you typically pay for overdrafts, using an out-of-network ATM, and making wire transfers.
Transactions may be limited
Due to a banking law called Regulation D, savings accounts have historically been limited to six monthly outgoing withdrawals. However, the Federal Reserve loosened that requirement in 2020, allowing unlimited transfers or withdrawals during the pandemic.
While the Fed hasn’t re-imposed savings transfer limits, some banks and credit unions may choose to put limits in place. Exceeding their limit could result in fees or restrictions on your account. So, be sure you understand the withdrawal rules for any HYSA you’re considering.
No physical locations
Since HYSAs are typically online-only banks, they may not have a physical branch you can visit. So, if you prefer face-to-face customer service or need to deposit cash regularly, a HYSA may not be the best choice.
However, some online banks have partnerships with ATM networks, where you can deposit cash, but it could be a hassle, depending on where you live.
To sum up, a HYSA can be an excellent place to keep cash for short-term needs. You receive above-average APY, relatively easy access to your money, and extremely low risk. However, keeping too much money in savings could hurt your finances in the long run if you don’t earn more than inflation erodes your wealth.
Even the highest APYs lag behind average annual stock market returns, which historically have been about 10%. Underinvesting and missing out on the potential growth of a well-diversified portfolio could be one of the most significant risks to your future financial security.
How to choose a high-yield savings account
See how different HYSA institutions stack up with the following:
- FDIC or NCUA insurance – ensure any online bank you choose has protections in case of failure.
- APY – is a percentage that includes the effects of compounding and represents how much interest your money will earn.
- Fees – could include overdraft fees, monthly service fees, and more that you should understand.
- Minimum opening deposit – may not be required but shows the least amount of cash you must have to open an account.
- Minimum balance requirement – may not be required but every financial institution has its own rules and could charge fees if your balance dips below a threshold.
- Convenience – including ATM availability, mobile banking, withdrawal limits, and various features that make it easy to access and manage your savings.
- Customer service – based on what you’re likely to need, such as contacting someone by phone 24/7 or chatting with an online help desk. You might look at reviews to gauge the quality of an institution’s reputation.
- Product range – including checking, CDs, credit cards, or other products you may want to have at the same institution.
- Security – look for institutions that offer two-factor authentication, encrypted communications, and other online security features.
Like any bank or credit union account, opening a HYSA doesn’t affect your credit scores. You’ll have to provide your full name, address, Social Security number, and a government-issued ID to open one. Once your HYSA opens, you can link it to your checking account for easy withdrawals and transfers, including your initial opening deposit.
While an online-only bank may not be the best option if you need in-person service or a wide range of banking products, using a HYSA with a competitive return, no fees, and user-friendly features is a terrific way to earn more on the savings you already have.