Money Market Funds vs. CDs: How To Choose

Key Takeaways

• Some investors might be overdoing their cash investments.
• A big pro to CDs really when you survey various cash options is that because CDs do require you to lock up your money for a period of time, typically, the yields are better than is the case with investments that give you a lot of liquidity and access to your funds on an ongoing basis.
• Money market accounts are bank offered accounts. Typically, they do come along with FDIC protection. Money market mutual funds are investment products, so they are not FDIC insured. And so, that’s the big distinction, and you typically will see higher yields on money market mutual funds, especially right now, relative to money market accounts, because money market accounts give you better safety protections.

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks to the Federal Reserve’s campaign to increase interest rates to dampen inflation, safe investments are offering higher yields than we’ve seen in years. Joining me to discuss how to choose between two popular options for your short-term funds is Christine Benz. Christine is Morningstar’s director of Personal Finance and Retirement Planning.

Nice to see you, Christine.

Christine Benz: Good to see you too, Susan.

How Should Investors Be Thinking About Cash?

Dziubinski: So, let’s start with a portfolio question. Yields on very safe cash-like investments are the highest we’ve really seen in years, and we’ve seen a flood of assets into things like money market mutual funds and other cash-like investments. So, how should investors in this environment be thinking about their cash positions today?

Benz: Yeah. Frankly, I’m a little worried that some investors might be overdoing their cash investments. It’s hard to deny that that safe yield is attractive. It certainly is. But I think you do want to be deliberate and strategic about how much you hold in cash. So, for people who are still working, I think the good rule of thumb is holding three to six months’ worth of living expenses in liquid reserves, in cash instruments, maybe a little bit more in cash if you’re an older worker with a more-specialized career path, or if you’re the sole earner in your family and you’re supporting a household, you may want to think about more like a year’s worth of living expenses and that can support you through all sorts of trials and tribulations, job loss, and so forth. If you’re someone who is retired, I like the idea of holding a bigger cash cushion as an ongoing spending reserve that you can pull from on an ongoing basis. And so, I think one to two years’ worth of living expenses of portfolio spending is a good benchmark for people at that life stage.

And then, I would say for folks who like to be a little bit opportunistic about their investments, if you’re someone who knows that you like a good buying opportunity in the market, you like to go shopping when stocks are on sale, you might hold a little bit more of a reserve alongside your investment accounts that will let you be nimble, will let you put money to work in those market inflection points.

Certificates of Deposit: Pros and Cons

Dziubinski: Got it. So, if investors are looking for those higher-yielding options, certificates of deposit certainly look compelling today. Let’s talk a little bit about their pros and cons.

Benz: Yeah. So, the big pro really when you survey various cash options is that because CDs do require you to lock up your money for a period of time, typically the yields are better than is the case with investments that give you a lot of liquidity and access to your funds on an ongoing basis. So, I think for people shopping for cash instruments, that’s going to jump out at them right away. They’ll see that the yields are attractive, and you typically have FDIC insurance protection up to the limits that comes along with certificates of deposit. So, those would be the big benefits.

The big negative would be the fact that you’ve got to lock up your money for a period of time, that part of the bargain in order to earn that tantalizing yield is that you do have to agree to keep your money in the account. Otherwise you will pay a penalty if you need to get at those funds prior to the term being up. You’ll pay a penalty usually equal to a couple of months’ worth of interest. So, you need to really think about your own spending needs before signing on the dotted line with the CD.

Dziubinski: So, then who would CDs be right for?

Benz: So, they’re right for people who have very specific spending needs coming due. So, retirees, I would say, would tend to be good candidates for CD investments because they have specific expenses that are coming due on specific schedules. They can readily calibrate how much to put into various CDs. I would say those would be the best candidates. Or if you are someone who has cash investments set aside where you don’t have any specific purpose for them, you just have cash in your portfolio, the CDs would generally be your highest-yielding option as long as you understand that you’re not going to be able to pull the funds just on an ongoing basis without some penalty.

Money Market Mutual Funds and Money Market Accounts

Dziubinski: Right. So, now, let’s pivot and talk about money market funds, which are another popular cash-like option. Now you say that there is a bit of a confusing terminology with money market funds. So, let’s start there. There are money market accounts, and then there are money market mutual funds. What’s the difference?

Benz: Right. It’s unnecessarily complicated, but it is what it is. Money market accounts are bank-offered accounts. Typically, they do come along with FDIC protection. Money market mutual funds are investment products, so they are not FDIC-insured. And so that’s the big distinction, and you typically will see higher yields on money market mutual funds, especially right now, relative to money market accounts, because money market accounts give you better safety protections.

Money Market Funds: Pros and Cons

Dziubinski: Got it. So then, what are the pros and cons of money market mutual funds?

Benz: So, money market mutual funds are able to offer higher yields, and it will kind of ebb and flow, but right now, they will offer higher yields than FDIC-insured instruments will. There’s also a convenience factor with money market mutual funds. Most of my cash is in a money market mutual fund that sits right alongside my other investment accounts. I’m able to make regular contributions to it. There’s just a seamlessness to the money market mutual funds. So, I would say those are the big advantages. The big disadvantage is that lack of FDIC protection. And in fact, we have seen a couple of bobbles with money market mutual funds. The biggie was during the global financial crisis in 2008, where we saw quite a large money market mutual fund, what’s called “break the buck” where it didn’t necessarily make all of its shareholders whole, which is not something that investors in cash-type investments are typically expecting. So, there have been some tightening up of the rules around how fund companies are running money market mutual funds. In practice, money market mutual funds have been quite safe, and the SEC, the Securities and Exchange Commission, is considering some new regulations that would make them even more so.

Dziubinski: So, Christine, then who might money market funds be a good fit for?

Benz: Well, they are a good fit for people who do have that ongoing liquidity need where you have maybe your emergency fund, for example, parked in a money market mutual fund, where you may even have check-writing privileges depending on the provider. The key point I would make here, Susan, is that it’s really worthwhile to shop around, look at the yield, also look at that expense ratio, which you can find by hopping on your fund company’s website. And if you see a very high yield— maybe higher than other competing cash investments and high-ish expense ratio, so maybe something more than, say, 0.50%—that’s a signal that maybe this is an investment product that’s dabbling in some riskier security types in order to deliver that high yield. So, I think there’s probably safety by sticking with one of the really big providers who have a lot riding on other investment products, not just money market mutual funds. Do your homework. Even though these seem like commodities, I think that you can do a little bit of due diligence to make sure that you’re not venturing into a risky product.

Dziubinski: Well, Christine, thanks for your time today and for helping us figure out the pros and cons of these two popular cash-like investments. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “How to Conduct a Midyear Investment Portfolio Review in 2023″ for more from Christine Benz.