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When interest rates are high, it's worth your time to compare different types of bank, credit union and investment accounts. If you're looking for somewhere to keep cash that you might need soon, a money market fund might offer better returns than you could get with high-yield savings accounts, and the fund's yield could quickly go up if interest rates rise. However, investing money in a money market fund could be riskier than putting it in a savings account.
What Is a Money Market Fund?
A money market fund is a type of mutual fund that invests in short-term and relatively safe investments. The fund earns interest on these investments and pays you your cut of the earnings as a dividend. Often, you'll receive monthly dividend payments, which you can reinvest in the fund or take out to save or spend.
Because your dividend payments depend on current short-term interest rates, money market funds can be an attractive place to keep cash when interest rates are high. Money market funds might even offer higher yields than you'll earn from a high-yield savings account, and your earnings might be exempt from state or federal income taxes with certain types of money market funds.
Note: It's easy to confuse the two, but a money market fund is not the same as a money market account. Money market accounts are interest-earning deposit accounts that combine elements of checking and savings accounts.
Unlike checking and savings accounts, money market funds aren't covered by Federal Deposit Insurance Corporation (FDIC) insurance. (FDIC insurance covers similarly named money market accounts.) However, money market funds held with a Securities Investor Protection Corporation (SIPC) member brokerage are covered up to $500,000 if your brokerage firm fails or uses your account to make unauthorized trades. (SIPC coverage does not protect you if your investment loses money or your fund doesn't perform as expected.)
Types of Money Market Funds
Fund management companies create and offer different types of money market funds, such as funds for institutional and individual investors. The funds can also have different minimum initial investment requirements and ongoing expenses. However, money market funds broadly fall into one of three categories depending on the types of investments they make.
Government Funds
Government money market funds are required to invest at least 99.5% of their money in cash, U.S. government securities and repurchase agreements—an agreement to sell a government security and repurchase it at a later time. These funds are sometimes distinguished by the specific type of government security. For example, a treasury government money market fund might invest at least 80% of its funds in U.S. Treasury investments, such as treasury bonds.
Municipal or Tax-Exempt Funds
Municipal money market funds, sometimes called tax-exempt money market funds, invest in municipal securities, such as local and state bonds. Generally, at least 80% of the underlying investments will have interest earnings that are exempt from federal personal income taxes. There are also state money market funds—the state's name may be part of the fund's name—that invest in securities with interest earnings that are exempt from the state's income taxes in addition to federal income taxes.
Prime or General Purpose Funds
A prime or general purpose money market fund invests in various types of low-risk and short-term securities. These can include the government securities you'll find in the other types of funds, along with other types of investments, such as corporate bonds and certificates of deposit.
Pros and Cons of Money Market Funds
Although they're relatively safe, you'll want to consider the pros and cons before investing in money market funds.
Advantages of Money Market Funds
- A relatively low-risk investment. Because money market funds invest in low-risk and short-term investments, they might not be as risky as investing in stocks, bonds or other types of mutual funds.
- Potentially higher returns than savings accounts. Money market funds may offer higher returns than you could get from savings accounts. The funds might also react to rising interest rates much faster than some banks increase the interest rate on their savings accounts.
- Low minimum investment requirements. Some funds have a low (or no) minimum investment requirement.
- Steady investment returns. As with some other types of fixed income investments, you might receive a steady stream of dividend payments.
Disadvantages of Money Market Funds
- There are fund fees. Money market funds often charge a fee, called an expense ratio, on the money you invest. Funds with high minimum investment requirements may also charge lower fees.
- Potential limits on withdrawals. Prime and municipal money market funds might charge withdrawal fees—or forbid withdrawals—when lots of people try to sell their investment in the fund at the same time.
- You might earn less than you could with other investments. There's often a correlation between risk and reward, and other investments might offer better long-term returns.
Can You Lose Money in Money Market Funds?
Money market funds are relatively safe investment options that have low credit risk—the risk that borrowers don't repay their loans. However, there's still a chance that you'll lose money if the loans that the fund invests in default. Additionally, other risks could result in losses.
For example, rising interest rates could lower the underlying value of the fund's investments. Or, if many people try to withdraw their money from a money market fund at the same time, the fund manager might have to quickly sell investments for lower-than-expected returns. Federal regulations can help limit these risks, but there's still a chance that you could lose money if you sell your money market fund investment when this happens.
The Bottom Line
Saving and investing are part of building a solid financial foundation, just like following a budget. High-yield bank accounts, money market accounts and money market funds may all be good options for your emergency fund. However, it's important to consider money market funds' returns, advantages and risks before investing in them.
While you're working on your financial future, be sure to keep an eye on your credit. You can get your credit report and FICO® Score☉ Θ free from Experian at any time to see where you stand.