Certificates of Deposit Versus Money Markets

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

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For people who want to generate some interest income from their savings, two popular choices are money markets and certificates of deposit (CDs). Both of these savings vehicles have advantages and disadvantages that are important to understand—including differences in terms, yields, pricing, conditions, and restrictions. Depending on market conditions and your personal circumstances, resources, and portfolio preferences, both can be beneficial if you are looking to earn a relatively secure stream of passive income but don't want to dive into securities like tax-free municipal bonds or corporate bonds.

Certificates of Deposit Overview

A CD is a special type of debt instrument issued by banks and other qualified financial institutions to individuals who want to invest their savings and earn interest income. When you buy a certificate of deposit, you are essentially lending money to the bank. The bank takes the money for a pre-determined length of time—often offering higher yields for longer-held funds—with a promise to repay it upon maturity. For FDIC insured banks, the bank's promise to return the money is covered up to the $250,000 FDIC limit. Even if the bank collapses, the owner of the CD will still get their money returned.

The bank turns around and distributes loans to borrowers, pocketing the difference between the interest it pays you and the higher interest it charges borrowers. It's a case of allocating risks, resources, and rewards to the parties that want to bear it for better system-wide outcomes. You don't have to worry about monitoring the credit risk of potential borrowers, and the owners of the bank generate a profit; much of which is distributed as a cash dividend. You decide how long you want to tie up your money and receive the interest rate that is quoted for that CD's duration. Depending on the type and terms of the CD you are buying, the interest income you earn will either be distributed to you monthly, quarterly, or annually. You can also add it to the value of the CD, allowing you to claim it at maturity. 

It has become common for the larger brokerage firms to allow customers to buy CDs in their brokerage and retirement accounts, such a Roth IRA or Rollover IRA. It can be advantageous because you can hold CDs issued by different institutions all in one single, convenient place, while still enjoying FDIC protection. This is great for wealthier investors who would otherwise hit the FDIC limits. If you prefer to buy your CDs from a single institution, another alternative is to use payable on death accounts to effectively increase your FDIC limit coverage, though that comes with its own downsides.

CDs worth $100,000 or more are called "jumbo CDs" and typically offer higher interest rates. In some cases, you can use a CD to create a secure line of credit, with the bank holding the CD as a form of collateral. It can be a way to give yourself increased access to potential liquidity as you earn interest income. If you need access to the money tied up in your CD earlier than the maturity date, how you go about getting it depends on 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. On the other hand, broker-traded CDs have to be listed similar 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 CD. 

Money Markets Overview

There are two different types of money market investments: accounts and funds. These may appear similar, but from a structure and risk perspective, they are different.

Money market accounts 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 a limit on the number of checks that can be written against the account during a six-month period without incurring fees.

Money market funds, also known as money market mutual funds, are not insured by the FDIC, but instead, are mutual funds that hold investments such as Treasury bills and CDs. 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, you might encounter something known as a stable value fund, which looks and acts like a money market fund, but the returns are backed by a contract with an insurance company.

Finding money market funds tailored to your optimal tax and income situation is never a problem for most people. 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 more money in your pocket than with competing products—including money market accounts and CDs, 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

With a CD, you can calculate your expected earnings before investing because you know your interest rate and tax bracket. This isn't possible with money market accounts or money market funds because the interest rate will vary over time. The interest rates are directly proportional to the investor's level of deposited assets, not to maturity as is the case with CDs. As a result, money markets are disproportionately beneficial to wealthier investors. 

CDs are an ideal solution for individuals who want to focus more on capital preservation than growth. Although CDs typically have higher interest rates than money markets, your money is locked up for a period of several months to years. Opting for a longer maturity involves a certain degree of opportunity cost risk; the longer you lock away your money, the more likely it is you will receive a higher interest rate. Money markets are very liquid, and you can withdraw your funds at any time with no penalties. Unless there is a liquidity crisis or fund-specific catastrophe, the odds are good that your money markets are going to be available to you with much less hassle.

The Bottom Line

Although both CDs and money markets are useful, those who need access to their capital or have much higher cash balances may want to go with money markets. For those who wish to align maturities with life events, or want to benefit from a willingness to lock away savings for an extended period, CDs are often the better portfolio selection. Talk with an investment advisor or other qualified professional to discuss what makes sense for your personal situation.