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Money market fund investing

Dr. Don TaylorDear Dr. Don,
What is the difference between a money market mutual fund and a money market account? If I have $2,000 to invest without any immediate need for it, which would be the most profitable?
-- Taryn Trepidation

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Dear Taryn,
You understand interest rates just fine, so we'll focus on your other concerns. A money market account, or MMA, is an interest-earning savings account offered by a FDIC-insured financial institution with limited transaction privileges. It is more formally known as a money market deposit account.

Regulation D, Reserve Requirements of Depository Institutions, spells out the transaction limitations, but in broad terms you are limited to six transfers or withdrawals per month with no more than three transactions as checks written against the account.

The interest rate paid by a financial institution on a money market account is usually higher than its passbook savings rate. Money market accounts also have a minimum balance requirement. You can shop money market account rates on Bankrate and learn more about the accounts by reading Michelle Samaad's article on money market accounts.

In contrast, a money market mutual fund, or money fund, carries no FDIC insurance and is simply a collection of short-term debt investments held by that mutual fund. Money market investments are debt securities that mature in 13 months or less. Money market investments are also called cash investments because of the short maturities.

The SEC requires the average maturity of investments in a money market fund to be less than 90 days, which also serves to limit risk when investing in money market funds.

When you own shares in a mutual fund, you own fractional interest in the investments held by the mutual fund. The value of a share of a money market fund should always be $1 -- it's the interest rate that fluctuates, not the share price.

The mutual fund industry strives very hard to protect the value of a share. That doesn't mean you can ignore the risk of the investments held by the fund, just that money fund managers will strive to preserve the share value.

Money market funds are classified by the type of debt they purchase. Government money funds invest in U.S. government and agency securities. Some government money funds are Treasury-only funds, while others buy a full range of government and agency securities.

Corporate (nongovernment) money funds invest in money market securities issued by businesses. Finally, tax-free money funds invest in money market securities issued by municipalities.

Money market funds typically quote a seven-day average yield versus an annual percentage yield, but the effective rate on a money market fund is comparable to the APY on a money market deposit account.

The problem with investing $2,000 in a money fund is that the annual account fee, along with the annual expense ratio, is going to decimate the account's return.

If you earn 3 percent on the fund, you'll get $60 in interest. If the account charges a $25 annual fee and half a percent in annual expenses, which is pretty reasonable for professional money management, you'll give back $35 of that return to the money market fund.

After all this, with $2,000 to invest and no immediate need for the money, I would recommend that you buy a certificate of deposit. Stay short if you think you might need the money. A better approach might be to put half in a short-term CD and half in a longer-term CD or savings bond.

If you don't think you're going to need the money, then put it where you can't easily get to it and pick up some extra interest. If an emergency crops up, you can cash in the CD or savings bond with an interest penalty.

Savings bonds have to be held for at least six months before they can be redeemed, and there is an interest penalty for early redemption when Series I savings bonds are redeemed between six months and five years from purchase.

-- Updated: July 1, 2005




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