Looking for a relatively safe place to stash money and trying to decide between a money market fund and certificate of deposit (CD)? "Right now, both are offering great rates for investors looking to invest some of their short-term money," says Richard Carter, vice president of Fixed Income Products & Services at Fidelity Investments. Here's how to figure out which may make more sense for you.
What is a money market fund?
A money market fund operates in much the same way as other mutual funds: It pools investors' money to buy a basket of securities. But instead of buying stocks, long-term bonds, and the like, a money market fund buys low-risk, short-term debt, such as US Treasury bills or commercial paper, with the objective of preserving principal and daily access to your money.
There are 3 different types of money market funds, each named for what they invest in: government,1 prime,2 and municipal or "tax exempt."3 Government funds invest in cash, US government securities, and repurchase agreements (to buy a security at a price and sell it back at an agreed-upon price) with US government securities and cash as collateral. Prime funds may invest in the same things but also corporate debt such as commercial paper and CDs. Municipal funds mainly invest in municipal securities and strive for income that is exempt from federal income tax and, in some cases, from state income tax.
A money market fund is an investment product (a security) and should not be confused with a money market account, also known as a bank money market deposit account, which is an interest-earning bank product insured by the FDIC that may come with a debit card or checks and may limit the number of withdrawals in a given time period. A money market fund seeks to preserve a $1.00 value per share, but it is not insured or guaranteed by the FDIC or any other government agency. It allows unlimited withdrawals, making it flexible, plus yields may edge slightly higher than rates on money market accounts, so be sure to compare.
What is a CD?
A traditional certificate of deposit obtained directly from a bank typically pays a fixed interest rate over a specified time period. In return for committing to leave your money in the CD for a certain number of months or years, its interest rate is generally higher than what is offered for a regular savings account that you can tap without paying an early withdrawal penalty. (Some banks offer variable-rate or step-up CDs with interest rates that change.) Typically, the longer the investment period, the higher the interest rate you'll earn. If you don't touch your CD until it reaches maturity, you get back your principal (what you paid for it) plus the interest. CDs are issued by banks and are insured by the FDIC up to $250,000 per depositor, per insured bank, for each account ownership category. If offered by brokerage firms, they are known as brokered CDs, which can be bought or sold before reaching their maturity dates on the secondary market.4
What are key similarities and differences between a money market fund vs. a CD?
| Money market fund vs. CD: Key similarities and differences | ||
| Bank traditional CDs | Money market funds | |
|---|---|---|
| May be appropriate for | Investors seeking potential greater returns on cash who are willing to commit to specific time periods | Investors focused on preserving the value of their investment who prioritize access to funds over rate of return |
| Investment period (maturity) | Varies months to years | No time commitment required |
| Access | Typically a penalty if withdrawn before maturity | Easily retrieve funds to get cash, pay a bill, or make another investment in your account |
| Growth potential | Limited over the long term, but possible to ladder to diversify across different time frames and rates | Limited over the long term |
| Current rates & yields | Not offered by Fidelity | Research current rates and yields |
| Earnings rate | Normally fixed for the term | Normally changes daily |
| Earnings payment | Typically principal and interest returned at maturity | Dividends accrued daily, paid monthly (plus occasional capital gains) |
| Product insurance or guarantee | FDIC | Not insured or guaranteed by the FDIC or any other government agency |
| Potential tax benefits | n/a | Municipal funds for taxable accounts (e.g., nonretirement) |
| Minimum investment | $0 or more | $0 or more |
When might a money market fund make sense?
A money market fund may make sense for fast, flexible access to your cash. If you already have an account with a brokerage firm, you may choose to put your cash in a money market fund until you use it to, say, pay a bill or buy a stock or other mutual fund.
When might a CD make sense?
A bank CD might be a better option if you can keep cash locked up for extended periods. Perhaps you're saving for a big expense such as a home renovation and want to limit risk while earning a fixed rate of interest as long as you avoid early withdrawal penalties. You might be able to lock in a higher rate for a set period before interest rates tumble. "When considering which CD to buy: First determine your holding period, then look for the best rate," suggests Carter.
But a bank CD with an early withdrawal penalty may not be the right choice when instant liquidity is important, like with an emergency fund. "For this reason, make sure you have enough cash in highly liquid form to cover your typical expenses plus some amount in an emergency fund first before you start contemplating the potential for higher rates available on CDs," says Carter.