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Chapter 5 Money Market Accounts—The Parking Lot
“The idea is to make a little money first and then to make a little money last.”
Do I Need to Read This Chapter?
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• Am I looking for a place to temporarily invest idle cash? • Do I want a relatively safe investment that usually pays slightly higher yields than bank savings accounts and certificates of deposits (CDs)? • Am I interested in an account where I can write checks and earn interest?
• Do I understand the major types of money market accounts,including tax-frees?
• Have I considered a money market direct account (MMDA)? • Are my money market investments insured? Safe?
As far as I am concerned,the money market is nothing more than a parking lot,a temporary area for buying and selling high-yield,short-term instruments of credit.In the money market,securities such as jumbo
certificates of deposit and short-term commercial loans are bought and sold. Since these securities carry higher-than-normal interest rates,they make money grow quickly.But they usually require large investments that only wealthyindividuals or large institutions can afford.That’s where money market funds come in.First made available in 1974,money market funds offer the smaller investor a chance to take advantage of the interest rates prevailing in the money markets by pooling people’s money.
How Does a Money Market Account Work?
Money market funds operate by combining many small investors’ funds to accumulate the kind of money needed to buy costly money market instruments.Since the instruments purchased by the fund have different maturities, the fund earns interest on a daily basis.Each investor receives his or her share of the interest by means of a regular statement,usually issued monthly.The amount earned on an investment varies continually as the prevalent interest rates in the money market rise and fall.
Money market funds are managed by investment firms and brokerage houses.The management fee is deducted from the fund’s earnings,but usually no redemption charges are imposed on the fund.Most firms transact business by mail,so a money market fund headquartered in Illinois,for example,may have shareholders in any of the 50 states.A minimum deposit is required to open a money market account;$1,000 is typical.You can add to your investment at any time,and your funds are completely liquid—you can make withdrawals whenever you wish.
Another important point about this type of investment:because of the liquidity of a money market fund,it is an ideal way to invest idle cash that might otherwise find its way into a low-paying passbook savings account.For example,placing the proceeds from the sale of securities into a money market fund until you’ve decided upon your next investment venture is a good way of earning continuous higher interest on your money.Certain money market funds are a part of a larger group of other types of funds (known as family of funds).The advantage is that keeping your money “in the family”permits you to move it easily from one investment to another as financial conditions change, withoutever leaving the “group.”
How Do I Start?
If money markets seem right for you,the first step is to decide which category is most suitable.Money market funds can be broken into three categories based upon the type of instruments in which the funds invest:
1. General money market funds.These invest primarily in nongovernmental securities,such as bank certificates of deposit,commercial loans,and banker’s acceptances.Of the three types of funds,general money market funds usually pay the highest interest rates. 2. Government-only money market funds.These invest only in securities issued by the U.S.government or by a federal agency.Such funds boast a somewhat higher degree of safety than the general money market funds,but they pay a little less. 3. Tax-free money market funds.These purchase only short-term,tax-exempt municipal bonds and are especially suitable for investors in high tax brackets.Although this type of money market fund is exempt from federal tax,it could still be subject to state and local income taxes since most states do not exempt taxes on municipals issued out of state.If you reside in a highincome-tax state,search out those municipal money market funds that purchase investments only within your state of residency.For example,a fund may obtain only New York securities so that all the income earned will be
“triple tax free”to New York investors.
How Do Money Markets Issued by Banks Work?
Banks entered the money market field in 1982 with their version of the money market fund:the money market deposit account.The MMDA was authorized by Congress in order to stem the $200 billion tide of withdrawals that banks claimed had been lured away by money market funds.
The MMDA is similar in many ways to the money market fund.It too is based on the pooling concept,allowing small investors to earn interest rates otherwise reserved for the large institutional investors or wealthy individuals.
Like a money market fund,an MMDA initially requires a minimum deposit as well as a minimum balance.However,as of 1986,federal regulations no longer mandated a minimum MMDA balance.Thus banks became free to enforce a minimum balance rule at their discretion,so don’t blame the government if your bank requires a high minimum balance.
Finally,as with a money market fund,an MMDA is a good way to invest cash for a short period.
What Are the Major Differences between the Money Market Fund and the MMDA?
When you invest in a money market fund,you become a shareholder in the fund.You and the other shareholders receive all the income earned by the fund’s investments,less a small management fee (usually about 1⁄2 percent annually).When you invest in an MMDA,on the other hand,you are not a shareholder but simply a depositor.Investors in MMDAs do not necessarily receive all the interest generated by their investments,but receive whatever interest rate the bank chooses to pay.Furthermore,the bank is free to invest your money any way it sees fit,even in investments that have little or nothing to do with the money market.Therefore,you have no guarantee that the interest rate you receive will truly reflect the money market rate.
Note,too,the differences in the way the money market funds and the MMDAs usually advertise the interest rates they pay.Money market funds normally advertise the current simple interest rate being earned by the fund. This yield,which is not guaranteed,can change daily as conditions in the money markets change.By contrast,banks often promote MMDAs by advertising the effective yield rate,which is usually a fraction of a point higher than the simple interest rate because of compounding.However,the effective yield rate can be misleading since it assumes that the bank will be giving compound interest on an unchanging interest rate for a full year.
Consider these differences when deciding between money market funds and MMDAs. They can be significant: 1.With an MMDA, you have a person-to-person relationship with a bank officer whom you know, in contrast to the rather anonymous through-the-mail relationship usually offered by the money market funds. For some investors, dealing with a personal banker is psychologically important. 2.The money market fund may be preferable if you plan on making frequent withdrawals from your account. You may be permitted unlimited withdrawals by check from the fund. With an MMDA, there is normally a limit of three checks per month. However, in most banks you can make deposits or withdrawals 24 hours a day by means of the bank’s automated teller machines.
You cannot do this with the money market fund. 3.With an MMDA, you may lose up to a month’s interest if you close out your account anytime within a given month. With a money market fund, this cannot happen because of the daily payments of interest.
As with any form of investment,safety is a factor to consider.Your investment in an MMDA offered by a bank or a savings and loan institution is insured by the federal government up to a maximum of $100,000.If safety is of overriding importance to you,choose an MMDA over a money market fund.However, you should realize that the money market funds have an excellent safety track record.This is because they invest only in short-term instruments issued by such secure institutions as government agencies,large corporations,and major banks.Remember,the shorter the maturity of an investment,the lower the risk.Why is this? If interest rates should rise rapidly,funds holding long-term maturities would find it more difficult to liquidate their low-yielding holdings. Furthermore,the Securities and Exchange Commission regulates money market funds very strictly.
Given their relative safety and numerous advantages,money market funds have earned their place as one of today’s most popular options.
And on the topic of safety,it is better to be wounded than always to walk in armor.
It’s a Wrap
•Money markets are an excellent place to park your money temporarily— and sometimes for the longer haul. •The principal you invest in money markets is safe,although not federally insured (unless you are investing in a money market deposit account at a bank). •Money markets allow you to withdraw your money at any time with no penalty. •Money markets earn interest rates that reflect current market conditions.
