Money markets: a liquid investment
In the land of low interest rates, savers hustle and bustle to find a high yield that still keeps them under the safe umbrella of the Federal Deposit Insurance Corp. Should investors remain in the shelter of a money market account, or should they risk a little more with a money market mutual fund? What about a CD?
In order to better understand these options, we asked Maclyn Clouse, Ph.D., the Sorensen Distinguished Professor of Finance at the Daniels College of Business at the University of Denver for his thoughts. He sheds some light on the subject of low-risk investing in the current market.
Money market shares fell due to the effects of the economic crisis in 2008, and as a result new rules were implemented. Is it still wise to consider money market accounts as an investment?
Money market mutual funds and money market accounts originally were introduced as a way consumers could earn an interest rate on a highly liquid investment that also allowed them to write checks (not exactly checks, but they worked like checks) from the shares or account. It was a way they could have an interest-bearing checking account, before those were officially allowed. They paid a rate of interest that was low but generally still greater than the inflation rate. Consumers weren't viewing these as an investment. It was a low- or no-risk way to earn interest on liquid dollars that could be spent at any time. Money market shares are FDIC-insured, so there is no risk up to the insured level. Money market mutual fund shares are not insured and, therefore, they pay a slightly higher interest rate. However, most consumers viewed the mutual fund shares as risk-free. They thought the NAV (net asset value) would always be $1, and no fund would "break the buck."
With today's low interest rates, money market shares are paying less than 1 percent; one of our large local banks is paying 0.05 percent, almost zero. The same is true for money market mutual funds. With these low returns, it is hard to say that they are investments.
What are the main differences (pros and cons) between investing in a money market account versus CDs in relation to the current economic situation? In your opinion, which is a better investment?
It used to be the case that a CD would pay you a higher interest rate than a money market account. A CD requires you to give up your liquidity. Therefore, you need to be compensated -- the longer the term of the CD, the higher the interest rate. The advantage of the money market account was that you could withdraw your money at any time; the disadvantage was the lower interest rate. Both the CD and the money market account are FDIC-insured, so there is no risk difference between the two. Today's rates are not much different between these two alternatives. Our large local bank is paying 0.05 percent on a money market account. It has a monthly service fee that will greatly exceed the monthly interest if your minimum balance is under $3,500. The bank's CD rate is the same -- 0.05 percent for a three-month, six-month or 12-month term. If you give up your liquidity for about four years, you can increase your rate to 0.9 percent; a term of about five years can get you 1.15 percent. For the CD, a minimum investment of $2,500 is required.
Neither of these is an attractive investment. Most finance people predict that interest rates will eventually increase. An interest rate of 0.9 percent or 1.15 percent in about four or five years from today may be very unattractive when rates do go up. It is hard to advise someone to lock up funds in a CD today when the rates are so close to the liquid money market account rates. For your liquid dollar needs, go for a money market account. However, for investment purposes, invest in neither.
We would like to thank Maclyn Clouse, Ph.D., professor of finance at the University of Denver, for his expertise.