Saving Accounts | CDs | Money Market Funds

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CDs and Money market Funds

Certificate of Deposit(CDs): A certificate of deposit ("CD") is a short to medium-term, FDIC insured investment available at banks, credit union and even at your online brokerage firm. CDs are debt instruments issued by banks and other financial institutions to investors. In exchange for lending your money to the institution for a predetermined length of time, the investor is paid a fixed rate of interest. Maturities on certificates of deposit can range from only a few weeks to several years with the interest rate earned by the investor increasing in proportion to the time his capital is tied up in the investment. So a CD with five years maturity period will earn a higher interest rate as compared to the one with one or two years maturity period.

A penalty is assessed if funds are withdrawn prior to maturity, resulting in the loss of a certain number of days of interest (the amount varies among financial institutions). If an early withdrawal penalty exceeds the interest earned, the difference will be deducted from an investor’s principal. Many people think that CDs can only be purchased at banks. Many credit unions and full-service brokerage firms also sell federally insured CDs to investors. Investment firms purchase the CDs of banks nationwide in large blocks and sell them to investors in small denominations. The difference between their buying and selling price, called "the spread," is how they make a profit. Since brokers shop the entire country for high yields, brokered CDs often pay more attractive rates than CDs at local banks. CDs can be redeemed prior to maturity, often without penalty, but, due to interest rate risk, the value of a brokered CD can be higher or lower than someone’s initial investment.

Another relatively new type of CD is the equity-indexed CD. Sold through both banks and brokers, these CDs base returns, in part, on appreciation of a stock market index like the Standard & Poor’s 500 (S&P 500). Many require a $5,000 initial investment ($2,000 for IRAs). Unfortunately, equity-indexed CDs rarely include the full appreciation potential of the S&P 500 because they exclude the portion derived from company dividends. Many also cap the maximum growth rate, which further reduces upside potential. As a result, most financial advisors suggest avoiding these CDs and buying regular CDs for income and a stock index fund for capital growth. Another important thing to remember is that your earning potential could reduced if index doesn't do well.

CDs offer a slightly higher yield than Treasury bills because of the slightly higher default risk for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of course, the amount of interest you earn depends on a number of other factors such as the current interest rate environment, how much money you invest, the length of time and the particular bank you choose. While nearly every bank offers CDs, the rates are rarely competitive, so it's important to shop around.

One of the most important factors in purchasing your CD should be interest rate and you want to make sure you check both numbers – Annual Percentage Rate(APR) as well as Annual Percentage Yield(APY). Using APY is one of the way credit card company charge you lot more interest than what they quote you on the offer. Most of the time APR is what is quoted and APY is what is charged. You should consider a CD with higher APY because interest is added at smaller intervals and then you earn compounding interest.

Money Market Funds: Money market mutual funds are a type of mutual fund consisting of high quality, short-term debt instruments such as Treasury bills and short term corporate IOUs. Like all mutual funds, money market mutual fund (MMMF) portfolios are professionally managed and a management fee is charged against fund assets to cover this expense. MMMFs offer market-based rates and are quick to respond to changing conditions because the average maturity of securities in their portfolio is 90 days or less. Money market mutual funds are better options than CDs in a rising interest rate environment. Remember, you want to put your money in higher interest rate investment when they are offered but CDs can tie up your cash for a longer period as compared to money market funds. Sometime there is a minimum initial investment in money market mutual funds and it is set by individual investment firms and can range from $250 to $25,000. MMMFs can be purchased directly from investment companies or with the assistance of financial advisors.

Unlike bank-sponsored money market deposit accounts (MMDAs), there is no FDIC insurance if a MMMF fails to maintain a $1 share price. Failures have happened very infrequently in the last 20 years, however, and most investment firms have shored up MMMF prices with other company assets to avoid a loss of principal by investors. Limited check writing is generally available on MMMFs with a minimum amount (e.g., $250) per check. Investors seeking both safety of principal and tax advantages can select tax-exempt MMMFs that include short-term securities issued by state and local governments. Other conservative choices are MMMFs that invest solely in Treasury bills and/or Treasuries plus debt of federal government agencies.

If you have a online brokerage account, you can purchase money market mutual funds just like any other mutual funds out there. If you're between investments and don't want to put your money in stocks, money market mutual funds are good option to keep earning interest on your cash.

Final Verdict

Although both CDS and Money market mutual funds can be useful, for those who need access to their capital, money markets are far superior. Many brokerage houses automatically sweep their customer’s un-invested cash into money markets to earn interest between investments. This is the ideal solution if you regularly invest because the funds can be used immediately to purchase stocks, bonds, or mutual funds. However, if you’re looking a place to park your emergency funds or cash, you may opt for a short term CDs such as 6 to 12 months to earn a better return. Also, your money invested in money market funds is still available just like an checking account and you can write checks to access your funds. There is no penalty like in CDs if you need to use your funds before maturity period. As you can see, both products are very competitive and well matched. What you should pick in the end is going to depend on your individual situation. If you're looking to earn more than a regular checking account interest, but need to have instant access to your funds, money market is the way to go. However, if you have some funds that you need to park somewhere for shorter periods without need them, CDs are the best options.