The U.S. stock market and U.S. bond market are both down 18% since December 2021. Neither are showing any signs of recovery. On the other hand, money market accounts are doing quite well with rising annual yields. This has caused many people to invest new money into money market accounts. An advantage of these accounts is that they are covered by FDIC insurance, giving investors a sense that their money is secure. But investors need to research their money markets carefully because not all of them are actually insured by the FDIC.
What is a money market account?
A central tenet of any financial plan is to have an emergency fund that can cover at least 3 and preferably 6 months of household expenses. This emergency fund should be held in “cash”. From an investment standpoint, cash means an account that is secure, non-volatile, and immediately available. The three types of accounts that are considered as cash accounts are (1) checking, (2) savings, and (3) money markets. These are often called “transactional accounts“. Although some financial experts also consider certificates of deposit to be cash accounts, they are better considered to be low-risk investments because the money deposited in them cannot be accessed for a set number of months. Because of this, money in certificates of deposit cannot be used in an emergency. The Federal Reserve reported that as of 2019, the median amount of money Americans held in transactional accounts was $5,300 however the mean amount was much higher, $41,600. This discrepancy is due to a small number of Americans holding a very large amount of money in transactional accounts, resulting in the average being skewed.
Most financial experts recommend maintaining 1-2 months’ worth of expenses in a checking account and 2-4 months’ of expenses in savings or money market accounts. Money market accounts and savings accounts are very similar but there are several important differences. Money market accounts often come with check-writing and debit card options, unlike savings accounts. Money market accounts generally pay higher interest rates than savings accounts to depositors. However, money market accounts usually require a much larger initial deposit than savings accounts with the interest rate varying depending on the amount deposited and held in the money market account.
Checking accounts generally earn little to no interest; indeed, many banks charge a monthly fee to checking account owners. Savings accounts do earn interest but it is minuscule – currently, savings accounts at large national banks typically only earn 0.01% annual interest. For the past several years, money market accounts also had very low interest rates that were about the same as savings accounts but in the past 6 months, these interest rates have risen to 3 – 4% annualized.
When a person deposits money in a money market account, the bank then uses that money to invest, typically in short-term bonds and treasury bills. The bank makes its money off of the interest on those investments by making the interest it pays the depositor slightly lower than the interest rate on the bank’s investments. As an example, at last week’s auction by the U.S. Department of the Treasury, the annualized interest on treasury bills ranged from 4.22% on 4-week bills to 4.70% on 26-week bills. Last week, my bank was offering money market accounts with a 3.50% annualized yield. So, if the bank uses money market deposits to buy treasury bills, it can make a net profit of about 1%. Banks can also use money deposited into money market accounts to make bank loans, such as mortgages, car loans, and business loans. The interest the bank charges on these loans is even higher than treasury bill interest rates. Banks assume that there is a predictable amount of money being deposited and withdrawn by money market account owners and assumes that everyone does not decide to withdraw all of the money market funds all at once.
What does being FDIC-insured mean?
An advantage of transactional bank accounts is that they are insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC is a United States government corporation created in 1933 in response to runs on banks that contributed to the Great Depression. Banks that are members of the FDIC pay the FDIC annual fees that are similar to insurance premiums. The FDIC then uses the proceeds of these fees to build up its reserves in order to insure the checking accounts, savings accounts, money market accounts, and certificates of deposit at member banks. Importantly, the FDIC is self-funded, meaning that it is not supported by public funds and does not depend on congressional appropriations.
Each individual’s total of all transactional accounts at a single bank is insured up to $250,000. That means that if you have a checking account, savings account, and money market account at an FDIC member bank, if the sum of all three accounts is less than 250,000, you are insured. Any amount over $250,000 deposited in an account is not insured and can be lost if the bank goes under. The FDIC’s reserves are currently $1.28 billion. In the event of massive bank failures, the FDIC also has a line of credit of an additional $100 billion from the U.S. Treasury Department. Because of this, FDIC-insured transactional accounts are considered the safest of all types of investments.
Money market funds are not FDIC-insured
Money market accounts are issued by banks. Money market funds are issued by investment companies. Although these two types of money markets are similar, there are important differences, the most important being that money market funds are mutual funds and are not insured by the FDIC. However, that does not necessarily mean that FDIC-uninsured money market funds are less safe than FDIC-insured money market accounts. As is often the case, the details are in the fine print.
When you deposit money in a bank’s money market account, the bank leverages that money to make loans and investments. The bank does not just keep that money in a vault somewhere. This creates a problem if there is a run on the bank by depositors because the bank does not have enough cash on hand to pay off all of the depositors at once. If this happens, the bank can become insolvent and go under, such as happened with Silicon Valley Bank recently. Unlike banks, investment companies do not make loans so all of the deposits in a money market fund are used for investments, typically in short-term U.S. government bonds and treasury bills. As an example, the Vanguard Cash Reserves Federal Money Market Fund has 99.5% of its funds held in cash or U.S. government securities (U.S. government bonds, treasury bills, and U.S. government securities repurchase agreements). The yield that a money market funds pays to its investors is directly related to the interest that the fund is getting from the government securities it buys. This week, Vanguard’s money market fund has an annualized yield of 4.55%. This is higher than the annualized yield of bank money market accounts but slightly lower than the current interest on 26-week treasury bills. Other money market funds offered by investment companies may be invested in municipal bonds, making the yield tax-exempt to depositors. High-risk money market funds may invest in corporate bonds or foreign currency certificates of deposit.
Money market funds also differ from money market accounts by check-writing and debit card privileges. These are not typically offered by investment companies to money market fund depositors. It also takes longer to withdraw money from a money market fund than a money market account. Generally, it takes 2-3 days (and up to 7 days) for money to transfer from a money market fund in an investment company into a checking account at your bank. However, most money market accounts held by your bank can transfer funds immediately into a checking account held in that bank.
When you invest money in an investment company’s money market fund, you are purchasing shares of that fund. The fund managers generally keep the price per share at $1.00. When the fund makes money, it pays you in dividends (not interest). So, when you make income off of the money invested in the money market fund, the price per share does not change but you end up with dividends. Usually, those dividends get reinvested in the money market fund resulting in you owning more shares of that money market fund. During the 2008 financial crises, the price per share of most money market funds dropped to $0.97, so investors lost 3% on their money market fund investments.
When depositing money in a bank’s money market, it is important to read the details carefully to be sure that the bank is offering an FDIC-insured money market account. As an example, Chase Bank does not offer a money market account through its regular banking services but it does offer a money market fund through its affiliated investment company, JP Morgan Asset Management. The current annualized yield on this money market fund is 4.47% but it is not FDIC-insured.
Nowhere does the phrase “Let the buyer beware” apply more importantly than investing. In this time of financial uncertainty with bank failures and the impending U.S. debt ceiling, it is essential that all investors be sure of the details of their investments. Money markets are currently highly attractive because they are generally safe and currently paying annualized yields that are better than can be had with stocks or bonds. Here are some of the considerations to take into account when considering a money market:
- Is your bank a member of the FDIC? If it is, then money market accounts offered by the bank are likely FDIC-insured. There are a few banks in the United States that are not insured by the FDIC so be sure that yours is an FDIC member bank. Credit unions are not insured by the FDIC but are insured by the equivalent National Credit Union Administration (NCUA).
- Is the money market offered by your bank insured by the FDIC? If your bank is an FDIC member and offers a money market account directly, then the money market is insured. But you do need to be careful because many banks will link their websites to their sister investment companies, often called “asset management” or “wealth management” companies with a similar name as the bank’s. These money market funds are generally not FDIC-insured.
- How much money are you putting in a money market? In general, you should avoid putting more than $250,000 in any single money market account. A common scenario is buying a new house. Let’s say you sell your current house for $500,000 and you are buying a new house for $500,000 but the closing date for purchase of your new house is two months after the closing date for sale of your old house. So you need to park $500,000 somewhere safe until you close on your new house. It is better to split the money into two $250,000 money markets – either into one owned by you and one owned by your spouse at a single bank or into two money market accounts in two different banks.
- Money market account versus money market fund. The deposits in an FDIC-insured money market account will be slightly safer than deposits in a non-insured money market fund. However the money market fund will probably pay a higher annualized yield than the money market account. You will need to weigh the risk versus reward associated with an account versus a fund.
- What is the money market fund invested in? If you do decide to deposit money into a money market fund, be sure that you read the details of how the fund manager uses those deposits. A money market fund that is totally invested in U.S. government securities is safer than a money market fund invested in municipal bonds. A money market fund that is invested in corporate bonds or foreign currency certificates of deposit is considerably riskier.
- How fast will you need to move the money? You can wire money from your bank’s money market account immediately but it can take up to a week to transfer money from your investment company’s money market fund into your checking account.
- Do you want to write checks on your money market? Although every bank and investment company has different rules, most banks will allow you to write a check or use a debit card to access cash in your money market account. Most investment companies do not offer check-writing or debit cards to withdraw cash from money market funds.
- Know your tax implications. Money market accounts will pay you interest, which is taxed at your regular income tax rate. Money market funds will pay you dividends, instead of interest. Dividends come in two types: ordinary dividends and qualified dividends. Qualified dividends are taxed at the dividend tax rate of either 0%, 15%, or 20%, depending on your taxable income. For most people, the dividend tax rate is lower than their regular income tax rate. Ordinary dividends, on the other hand, are taxed at your regular income tax rate, just like interest is taxed. Most money market funds will pay out ordinary dividends and not qualified dividends. Money market funds invested in municipal bonds are generally tax-exempt.
- When to consider treasury bills instead of a money market. Every week, the U.S. Treasury Department auctions federal securities. Treasury bonds mature in 20-30 years, treasury notes mature in 2-10 years, and treasury bills mature in less than 1 year. For some people, purchasing a treasury bill directly from the Treasury Department can be a good alternative to a money market. Treasury bills are similar to a certificate of deposit in that the money cannot be accessed until the bill matures. The advantage of a treasury bill is that it generally pays a higher rate of return than money market accounts at a bank. Just be aware that if the federal government reaches the debt ceiling without congressional action, you may not be able to get paid once a treasury bill reaches its mature date. Currently, treasury bills with mature dates of 4, 8, 13, 17, and 26-weeks are available for purchase. The most recent annualized rates range from 4.22% for 4-week bills to 4.70% for 26-week bills.
The good news is that both money market accounts and money market funds are generally safe and currently offering better annualized yields than other common investments. Just be sure you know what you are putting your money into before you hand over your cash.