Money market funds are mutual funds that investors typically use for relatively low-risk holdings in a portfolio. These funds typically invest in short-term debt instruments, and they pay out earnings in the form of a dividend. A money market fund is not the same as a money market account at a bank or credit union.
There’s a big difference between money market funds and money market accounts. Funds are mutual funds that invest in securities, and they can potentially lose value. Money market accounts are often FDIC insured bank accounts.
Money market funds often pay a monthly dividend, but some alternatives exist.
Money market funds are a popular and useful cash management tool in the right circumstances. Before you use money market funds, make sure you understand how they work and the risks you might be taking.
Money Market Fund Investments
Money market funds invest in short-term securities. By keeping a short time frame, these funds attempt to reduce uncertainty, which may help to manage risk. These funds are required to keep investment maturities to 397 days or less.
The longer you lend money to a person, business, or government, the greater the risk that something could happen, and you won’t get repaid. Typical investments inside a money market fund might be U.S. Treasury issues, short-term corporate paper, and other securities that present a relatively low risk of default.
You don’t select the investments inside of a money market fund. Instead, a fund manager does that for you.
Different funds might have different underlying investments. For example:
- Government money market funds primarily invest in government-issued securities
- Municipal money market funds favor issues from municipal bodies
- Prime money market funds might invest in corporate and bank securities to maximize the yield
Why Use Money Market Funds?
Several factors make money market funds attractive to investors.
Investors use money market funds when they want a cash-like investment. These investments may provide a small return while assuming limited risk. Contrast that with a portfolio invested heavily in stocks. You can often reduce risk by switching to a money market fund or keeping some portion of your assets in these investments.
Investments in money market funds are typically liquid, meaning you can usually get your money out within a few business days. It generally takes one trading day for a mutual fund sale to settle. After that, you may have to transfer the funds to an account that allows spending.
Some institutions allow you to write checks to withdraw your funds from a money market fund. As a result, you get the advantages of dividend earnings as well as easy access to your cash. Make sure you ask what restrictions or fees your institution has.
Money market funds may pay higher or lower rates over time. If you expect rates to rise, keeping your money in an investment that adjusts to the markets might be appealing.
Due to the understandable trade-offs between risk and return, you might expect money market funds to provide long-term returns that are relatively low.
Potential Risks of Money Market Funds
There are several risks you need to know about, including the risk of losing money.
You Could Lose Your Principal
The fund managers attempt to keep the share price constant at $1 per share. However, there is no guarantee that the share price will stay at $1 per share. If the share price declines, you can lose some or all of your principal.
Money Market Funds Are Not FDIC Insured
If you keep money in a regular bank deposit account, such as savings or checking, your bank provides insurance for up to $250,000 from the Federal Deposit Insurance Corporation (FDIC). Although money market funds are relatively safe, there is still a small amount of risk that could have disastrous consequences if you can’t afford any losses. There is no government entity covering potential market losses.
In return for that risk, you should ideally earn a better return on your cash than you’d earn in an FDIC-insured savings account.
Money Market Fund Rates Are Variable
You cannot know how much you’ll earn on your investment as the future unfolds. The rate could go up or down. If it goes up, that may be a good thing. However, if it goes down—and you earn less than you expected—you may end up needing more cash to meet your goals. This risk exists with other securities investments, but it is still worth noting if you're looking for predictable returns on your funds.
Potential Opportunity Costs and Inflation Risk
Because money market funds are considered to be safer than other investments such as equities, long-term average returns on money market funds may be lower than long-term average returns on riskier investments. Over long periods, inflation can eat away at your returns, and you might be better served with higher-yielding investments if you have the capacity and desire to take the risk.
In some cases, money market funds can become illiquid, which helps to reduce problems during market turmoil. Funds can impose liquidity fees that require you to pay for cashing out. They may also use redemption gates, or temporary suspensions, which require you to wait before receiving proceeds from a money market fund.
Where to Get a Money Market Fund
When it comes to money market funds, you have choices. They are plentiful at brokerage houses and mutual fund companies—any free cash in your accounts might automatically go into a money market fund.
Before investing in a money market fund (or any other fund), read the fund’s prospectus carefully. This disclosure document explains some of the risks, fees, minimums, and other features of each fund.
Frequently Asked Questions (FAQs)
How are money market funds taxed?
Not all money market funds are taxable, so if you're concerned about taxation, you may want to consider a money market fund that invests in tax-free municipal securities. Other money market funds do incur taxable events. If you own one of those kinds of funds, you will receive a 1099-INT to help you file your tax returns. Most interest will be taxed at your federal tax bracket rate.
How much are money market accounts yielding?
According to the FDIC's latest national rate information, money market accounts are yielding around 0.08% on average. Money market funds carry more risk than FDIC-insured money market accounts, so you can expect them to yield a bit higher than 0.08% on average.
How often do money market funds pay interest?
Most money market products pay interest monthly, but this isn't a set rule. You can check a fund's distribution history to learn more about how much and how often it pays fund shareholders.