Cash management strategy is central to the success of any financial plan. With good cash management techniques, you can maintain liquidity and collect interest to make timely bill payments, purchase big-ticket items, and even acquire additional assets that compound even more wealth. As part of your cash management plan, you may weigh the merits of putting money into a money market deposit account as opposed to a money market mutual fund.
The money market refers to the Universe of credit securities that mature in less than one year. Money market securities include treasury bills, commercial paper, and short-term bonds. You may buy into a money market mutual fund through a broker – to invest in the money market. One share of a money market fund represents claims over hundreds of different money market securities.
Alternatively, banks offer money market deposit accounts to customers in order to secure financing. With this money, banks can purchase investments and make loans. The bank makes money when it invests cash at a higher rate of return than your corresponding interest payment. To turn a profit, the bank does not necessarily have to invest your deposits into the money market.
The FDIC insures $250,000 worth of deposits per customer, per bank. Money market mutual funds do not feature FDIC guarantees, because funds are classified as investments. Although unlikely, it is possible for you to lose money with a money market mutual fund.
As banking deposits, FDIC coverage does extend over money market deposit accounts. If you are a large saver, you will divide cash between several different banks to guarantee your entire balance. For example, you would divide up $700,000 into seven money market deposits of $100,000 each to guarantee the entire balance. A $700,000 lump sum deposit would leave $450,000 without FDIC insurance.
Money Market Rates and the Federal Reserve
Banks loan money to each other overnight at the federal funds rate to meet their Federal Reserve requirements. The federal funds rate is a benchmark, or comparison standard, for all interest rates. Because of their short-term nature, interest rates and returns on money market deposit accounts and funds closely track the federal funds rate. You can expect low returns on bank deposits and money market funds amid recession. In recession, the Federal Reserve Board lowers rates to encourage people to take out loans, purchase durable goods, and commit to investing money. When the economy returns to form, you can expect the Fed to drive rates higher to shield the economy from inflation. At that point, money market deposit accounts and funds will also offer higher interest rates.
Money market deposit accounts and funds are both susceptible to inflation and opportunity cost risks. Inflation describes a rising price level, which erodes the purchasing power of cash over time. According to the U.S. Bureau of Labor Statistics Consumer Price Index, domestic inflation runs at a 3 percent annual clip. In some cases, the Fed may not raise rates quickly enough to keep pace with inflation. Meanwhile, opportunity cost risk relates to the potential profits you could have made from other investments. Returns on money market deposit accounts and funds appear to be even more minimal when the stock market is performing well.
Money Market Deposit Accounts Versus Money Market Mutual Funds, Sources:
Federal Reserve Board: Purposes and Functions
SEC: Money Market Funds
Investopedia: Money Market Account