This year, many investors learned the hard way the difference between a money market account and a money market fund. Do you know the difference?
A money market account is a type of deposit account. Much like its siblings, the checking and savings account, a money market account is FDIC insured, your principal is guaranteed, and you open one at a regular bank. It’s like a hybrid checking and savings account because it earns interest like a savings account but you can write checks against it, often three to six times a month. You can withdraw your money whenever you like and the interest rate can change at any time.
A money market fund is a mutual fund. It is not FDIC insured, your principal is not guaranteed, and it is a security, you buy it through a broker. Technically, it’s just like any other mutual fund. What makes a mutual fund a money market fund is what it invests in. Money market funds invest in supposedly “safe” investments like bonds and short term commercial paper, also known as “the money market.”
For the longest time, everyone assumed that money market funds would never “break the buck,” which is when the share price fall under $1 a share. That assumption was never tested until this year. When Lehman Brothers failed, its bonds failed and money market funds holding these assets lost a tremendous amount of money. The government eventually stepped in and prevented them from falling under $1/share but they didn’t have to; a money market fund is an investment and investments are risky.
With online banks offering extremely high interest rates, the speed and simplicity of ACH transfers, and 6% APY reward checking accounts, I don’t know why money market accounts still exist. Money market funds, on the other hand, still have value because you can find tax-exempt or tax-advantaged funds. They are especially appealing in a higher tax bracket because the tax equivalent yield can often beat other “safe” investments.
Jim writes about personal finance at Blueprint for Financial Prosperity.