There are a number of reasons to keep a portion of your assets in cash or cash equivalents, such as money market accounts (MMA) or certificates of deposit (CDs). A well-conceived financial plan dictates that you maintain an emergency fund worth six to 12 months of your living expenses. You can use MMAs and CDs to diversify your investment portfolio or to fund a short-term goal.
MMAs and CDs may seem interchangeable. They are both bank products offering low yields with maximum peace of mind. However, choosing between them ultimately depends on the specific objective you have for the cash and your need for liquidity. Understanding the differences between the two is the key to determining which is the most appropriate vehicle for your needs.
How Money Market Accounts Work
An MMA is a type of mutual fund that invests in very short-term interest-bearing instruments to generate a variable yield while preserving principal. They tend to credit interest rates that are higher than savings accounts, but they often require a higher minimum deposit. Some accounts also require a minimum balance to receive the highest rate.
The interest rates on MMAs are variable, which means they rise and fall with the interest rate market. Most MMAs come with limited check writing and balance transfer privileges. However, federal regulations limit the number of transactions in MMAs to six per month. As with any bank deposit, money market accounts are insured by the Federal Deposit Insurance Corp. (FDIC) for up to $250,000 per person per account.
There are important differences between money market accounts offered by banks and money market funds offered by brokers or mutual funds. Money market funds work similar to MMAs, except money market funds are not insured by the FDIC. Money market funds are typically offered as an option in 401(k) plans. In October 2016, new rules will apply to money market funds that will affect their liquidity.
How Certificates of Deposit (CDs) Work
Certificates of Deposits are best described as timed deposits that credit a fixed rate of interest tied to a maturity date. A longer time of deposit results in a higher rate of interest. CDs are issued with maturities as short as one month to as long as 10 years. With traditional CDs, banks charge a penalty for withdrawing money prior to the maturity date. Some banks now offer no-penalty CDs that allow you to withdraw your money without penalty, but you are likely to receive a much lower rate of interest for the privilege. Other types of CDs allow you to withdraw only interest without penalty. CDs are also insured for up to $250,000 per person per account.
When an MMA Is Better Than a CD
Generally, an MMA is a better vehicle to use when you have or may have an immediate need for cash. If your car engine blows up, you would not want to pay a penalty for prematurely withdrawing money from a one-year CD. If you have a near-term purchase planned, such as a new car or a major appliance, an MMA provides greater flexibility from a liquidity standpoint.
MMAs may also be a better choice in a rising interest rate environment. Banks periodically adjust the yield on MMAs, offering the opportunity to earn more on your money as interest rates rise. However, you can achieve the same effect with higher yields by investing in short-term CDs and rolling them into higher-yielding CDs as they mature.
When a CD Is Better Than an MMA
CDs usually offer a higher yield than MMAs. A longer maturity date means that you receive a higher interest rate. If you absolutely don't have a need for the money, you could lock in a higher rate for a period of time. CDs are often used to fund goals within a 10-year time frame, when you may not want to risk the price fluctuation of market-based options such as a stock mutual fund.
Although investing in longer-term CDs can secure a higher fixed rate, it would be a disadvantage during a period of rising interest rates. If you think that interest rates will rise for a period of time, you would be better off investing in shorter-term CDs. Some banks offer variable rate CDs with rates that will increase as interest rates rise, but their initial yields tend to be lower than those of traditional CDs.
You could also employ a CD laddering strategy to balance your need for liquidity with obtaining higher yields. For example, you could invest equal amounts in one-, two- and three-year CDs. When the one-year CD matures, it is rolled into a new three-year CD. After the two-year CD matures and is rolled into another three-year CD, you then have a three-year CD maturing every year that follows.
Longer-term laddering strategies might use five-year CDs, which can boost your average yield even higher. The net effect of the strategy is the ability to capture higher interest rates as the CDs mature while always staying invested and maintaining a degree of liquidity with CDs that mature each year.