Certificates of Deposit Versus Money Markets

Deciding Whether a Certificate of Deposit or Money Market Is Better for You

Investing in Money Market Accounts and Certificates of Deposit
When giving your money to a bank in exchange for interest payments, one of the major choices you will have to face is whether to invest in a certificate of deposit or a money market account. Image Source / Getty Images

For investors who want to generate interest income from their savings, two popular choices in the United States over the past few generations have been money markets and certificates of deposit.  Both of these investments have advantages and disadvantages including differences in terms, yields, pricing, conditions, and restrictions, all of which are important to understand if you want to make the best decision for your own situation.

 Depending upon both market conditions and your unique, personal circumstances, resources, and your investment portfolio preferences, either, or both, can meet your needs when you are looking for a place to earn a relatively secure stream of passive income but don't want to dive into securities such as tax-free municipal bonds or corporate bonds.

In this article, I want to take some time to walk you through the basics of investing in both money markets and certificates of deposit, highlighting things you might want to consider and contrasting them, so you have a better idea about what makes them different.  It is my hope that by the time you have finished reading it, you will feel much more comfortable when, at some point in the future, you decide to add one or both of these investments to your personal balance sheet; that you find yourself armed with knowledge that can help protect you from making mistakes or stumbling into a situation you would have rather avoided.

A Basic Overview of Certificates of Deposit

A certificate of deposit, also known as a CD for short, is a special type of debt instrument issued by banks and other qualified financial institutions to savers who want to invest their savings and earn interest income.  The bank takes the money for a pre-determined length of time, often rewarding investors with higher yields the longer they tie up their funds (though this may vary with the shape of the yield curve) and promises to repay it upon maturity.

 For FDIC insured banks, the bank's promise to return the money tied up in the certificate of deposit is covered by the government up to the FDIC limits so even if the bank collapses, the owner of the CD should still get his or her money returned.

In effect, when you buy a certificate of deposit, you are lending money to the bank.  The bank turns around and makes loans to borrowers, generating a spread between the interest it pays you and the higher interest it charges borrowers.  Done correctly, everybody wins.  It's a case of capitalism doing what capitalism does best: Allocating risks, resources, and rewards to the parties that want to bear it for better systemwide outcomes.  You don't have to worry about monitoring the credit risk of potential borrowers, effectively outsourcing the underwriting of bank loans to the bank, and the owners of the bank generate a profit, much of which is distributed as a cash dividend.

When you buy a certificate of deposit, money is taken out of your account (or you somehow deliver the funds, such as writing a check or wiring cash to the financial institution).  In days gone by, you were given a physical certificate to keep until maturity, but in modern times, it's mostly electronic; figures on a computer screen or printout.

 You decide how long you want to tie up your money and receive the interest rate that is quoted for that duration of CD.  Depending upon the type of certificate of deposit you are buying, and the terms, the interest income you earn will either be distributed to you monthly, quarterly, or annual basis, or it will be added back to the value of the certificate of deposit, allowing you to claim it at maturity.  

In recent years, it has become common for the larger brokerage houses to allow customers to buy certificates of deposit in their brokerage and retirement accounts, such a Roth IRA or Rollover IRA.  It can be advantageous because you can hold certificates of deposit, issued by many different institutions, over time in a laddered portfolio all in a single, convenient place, still enjoying FDIC protection.

 It is great for wealthier investors who would otherwise hit the FDIC limits.  (Another alternative, if you prefer to buy your certificates of deposit from a single institution, is to use payable on death accounts to effectively increase your FDIC limit coverage, though that comes with its own downsides.)  

Certificates of deposit worth $100,000 or more are called "Jumbo CDs" and typically command higher interest rates.  

In some cases, you can use a certificate of deposit to create a secure line of credit, the bank holding the CD as a form of collateral.  It can be a way to sort of have your cake and eat it, too; to give yourself increased access to potential liquidity as you earn interest income.

If you need access to the money you've tied up in your certificate of deposit earlier than the maturity date, how you go about getting it depends upon the institution and the specific CD you acquired.  Most traditional banks will redeem it for you in exchange for an interest rate penalty, such as giving up six months' worth of interest income.  Broker-traded certificates of deposit, on the other hand, have to be listed akin to the way bonds are sold between investors.  You'll have to wait for someone to make a bid on it, and it could be less than the accrued value of the certificate of deposit.  

A Basic Overview of Money Markets

When investors talk about money markets, they often don't realize there are really two different types of money market investments.  These may appear similar but, structurally and from a risk perspective, they are very, very different.

Money Market Accounts - These are special FDIC insured savings products offered by banks.  They tend to pay higher interest rates than regular savings accounts but have limited withdrawal rights, such as imposing a limitation on the number of checks that can be written against the account during a six-month period without incurring fees.  To learn more about them, read What Are Money Market Accounts?.

Money Market Funds - Also known as money market mutual funds, these are not insured by the FDIC but, instead, are mutual funds that hold investments such as Treasury bills and certificates of deposit.  Money market funds are designed to maintain a value of $1 per share at all times, but when they fail to do so, it is known as "breaking the buck" and can cause a run on the fund.  (If you are investing through a 401(k) plan at work, you might encounter something known as a stable value fund.  Many times, these look and act like money market funds but are, instead, returns backed by a contract with an insurance company, which provides a guarantee of a given compounding rate or range of compounding rates.)  You can find money market funds tailored to your optimal tax and income situation.  For example, if you are a high income earner living in New York City, during periods of normal or high interest rates, finding a money market fund that specializes in tax-free New York municipal bonds and securities can mean keeping a whole lot more money in your pocket than competing products, including money market accounts and certificates of deposit, even if the latter appears to offer higher yields at first glance.  Of course, this doesn't matter if you are investing through a tax-deferred or tax-free retirement plan. 

Comparing Certificates of Deposit and Money Markets

A few things come to mind when thinking about which type of investment is better:

  • With a certificate of deposit, you can calculate your expected earnings at the outset of the investment.  You know your interest rate.  You know your tax bracket.  It isn't possible with money market accounts or money market funds because the interest rate will vary over time and isn't locked in the way it is with a certificate of deposit.
  • Certificates of deposit are FDIC insured for up to $250,000.
  • Certificates of deposit are an ideal solution for the elderly near the end of their life expectancy who want to focus more on a capital preservation mandate - keeping what they have rather than worrying about growing their funds - for the remainder of their lifetime.
  • With a certificate of deposit, opting for a longer maturity involves a certain degree of opportunity cost risk.  The longer you lock away your money, the likely it is you will receive a higher interest rate.  It can be great, especially if rates subsequently decline as you are tied into to the richer payouts.  On the other hand, you don't have easy access to your funds for a longer span of time, reducing your flexibility.  In contrast, unless there is a liquidity crisis or fund-specific catastrophe, the odds are good your money markets are going to be available to you with much less hassle and fuss; a phone call, written check, or mouse click away from being moved wherever it is you want the money to go.
  • With money markets, the rate of interest is directly proportional to the investor's level of deposited assets, not to maturity as is the case with certificates of deposit. As a result, money markets are disproportionately beneficial to wealthier investors.  

The verdict?  Although both certificates of deposit and money markets be useful, for those who need access to their capital and / or have much higher cash balances, money markets are often the superior choice.  For those who want to time maturities to certain events or benefit from a willingness to lock away savings for a long period of time, certificates of deposit are often the better portfolio selection.  Your unique situation will vary, and you may want to discuss your options with an investment advisor or other qualified professional, but all else equal, those general rules should provide a satisfactory framework for decisions.