Saving money is an excellent habit, using this money to pay bills, use for emergencies, large purchases, and to make investments. However, in a low interest-rate environment, it can be challenging to earn income in saving accounts, especially a money market account. That may change as the Federal Reserve hikes interest rates in 2022 to battle the highest inflation in over 40 years, making money market accounts more appealing.
In the late 1970s to early 1980s, as inflation rose to nearly reached 15%, the Fed boosted its fed funds interest rates to 19.10% in June 1981 to calm higher prices. That higher rate influences the interest you pay on credit cards, auto loans, and even mortgage rates, making borrowing more expensive. On the positive side, it boosts savings rates like money market accounts.
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December 1980 Yields On Money Markets
Money market accounts contain securities, including Treasury bills, certificates of deposit (CDs), and commercial paper (CP). According to the St. Louis Fed (FRED), they were all generating healthy double-digit yields for three-month maturities in December 1980 when inflation averaged 13.5% that year:
- T-Bills 15.49%
- CPs 18.07%
- CDs 18.65%
No one expects we will see such high inflation and interest rates with current money market rates in the 0.50-1.00% level. Still, money market accounts keep better pace with rising prices and provide safety, access to your money, and the ability to earn higher interest income than a regular savings account.
We’ll define money market accounts, and differences they have with money market mutual funds, followed by their benefits and drawbacks. Let’s get started.
What is a Money Market Account?
A money market account (MMA), sometimes called a money market deposit account (MMDA), is a particular interest-bearing account that pays relatively high-interest rates compared to ordinary savings accounts.
These accounts were first offered in the early 1980s, encouraging customers to open accounts at higher interest rates. Prior to that, banks would offer toasters, blenders, and even color TVs to attract customer deposits so banks could make more loans.
MMAs are not marketable securities though they contain money market securities. Traditional banks, online banks, and credit unions are depository institutions that offer these accounts. Online banks tend to offer competitive interest rates given their lower overhead costs than brick & mortar banks, and therefore it may be a better choice to stash your money.
Investors deposit money into the bank. The bank invests in money market securities and takes on the risk, guaranteeing a return to investors on their MMA.
Money market accounts vary by financial institutions. They:
- Provide check-writing privileges and debit card privileges.
- Have minimal balances and may charge your account if the balance goes below the minimum requirement.
- Adjust their annual percentage yields based on interest rate changes based on economic conditions.
- Have withdrawal rights and transfers of up to six times a month, but these restrictions may not apply if you go to the bank or an ATM.
Differences Between Money Market Accounts and Money Market Mutual Funds
Although they sound similar and cause some confusion, money market accounts and mutual funds have notable differences in insurance coverage, returns, and risk. Both have initial minimums, but MMMFs don’t have the withdrawal restrictions of the MMAs.
Depository financial institutions offer MMAs, and customer accounts are either FDIC-insured as banks or NCUA-insured as credit unions should the institution fail.
Brokerage and mutual funds offer money market mutual funds (MMMF) and do not have government insurance viewed as providing more protection. Instead, when you open a brokerage account or have a mutual fund, safety comes from SIPC (Securities Investment Protection Corporation) if the brokerage firm fails to $500,000 per customer per separate capacity account. However, SIPC doesn’t protect against market losses.
Risk And Return
The respective bank or credit union sets the interest rate and therefore is a guarantee for the MMA, whereas the money market mutual funds’ performance is its returns. MMMF’s yields may be slightly higher due to higher risks than the MMAs.
Money market accounts and money market mutual funds vary in risk. Mutual fund investors hold securities in the fund, whereas money market account holders receive a guaranteed return from the bank. The bank has more risk by investing in money markets when setting up the money market account.
Lehman Brothers’ Downfall
While money market securities typically have minimum risk, mainly inflation risk, commercial paper issued by corporations carries credit risk. At the time of Lehman Brothers’ downfall in September 2008, one money market mutual fund held Lehman commercial paper when Lehman filed for bankruptcy. That MMMF’s net asset value dropped to $0.97 when they wrote off the Lehman commercial paper. This event raised fears in the money markets. It was money market investors who were buying securities in money market mutual funds that experienced more risk and are not guaranteed a return, unlike MMA holders who receive guaranteed returns from the bank.
Benefits of Money Market Accounts
1. Designed For Saving Money
These MMAs are for saving money for your goals at higher rates than standard bank savings accounts and are excellent vehicles for emergency funds, large purchases, or home renovation projects. Specifically, these accounts are for intermediate savings goals, encouraging you to save money more readily by paying yourself first.
2. Safe Place To Keep Your Money
Money market accounts carry FDIC insurance up to $250,000 per bank depositor ($500,000 for joint accounts), per institution, and each account ownership category. Credit union MMAs have similar insurance provided by the National Credit Union Union Administration (NCUA).
As such, MMAs are a safe way to save money. Depository institutions vary in whether they require minimum balances and may penalize customers who don’t maintain minimum deposits. They tier interest rates based on higher balances and higher income potential.
3. Flexibility Having An MMA At Your Bank
You can manage your monetary assets with more flexibility when you have deposited funds, checking accounts, and ATM at the same bank while automating your finances to pay bills. This advantage is superior to investing in an MMMF, which may not have the same abilities.
4. Have Higher Interest Rates Than Standard Savings Accounts
Money market accounts are a combination of cash and money market securities like Treasury securities, certificates of deposits or CDs, and commercial paper. They tend to have higher returns than high-yielding savings accounts, which don’t have money market securities.
According to the FDIC, earned interest rates could be twice as high for money market accounts as savings accounts, depending on how much you invest. Some institutions provide tiered interest rates that rise with higher balances.
Still, with the Fed keeping their fed funds rate near zero, all interest-bearing accounts generated minimal interest income in recent years. However, the Fed will likely be more aggressive about raising interest rates to fight high inflation. As they do so, the gap between standard savings accounts and MMAs will likely widen, with MMAs having higher relative rates.
If you are looking for high returns but don’t need access, you may want to consider Government Savings Series I Bonds, yielding 7.12% annually now and likely to go higher in April 2022.
5. Provide Liquid Access To Your Money
You can consider MMAs as monetary assets that are part of your net worth. MMAs have reasonable liquidity characteristics meaning they can be converted easily into cash and are part of your liquid net worth. They are more readily accessible than other household assets.
6. Compound Interest
Like all interest-bearing accounts, money market accounts will benefit from the power of compound interest, which is earning of interest on interest. The compounding effect helps your money grow faster. Because MMAs have higher rates, the incremental interest gain will be more significant to the principal balance, and over time, your money grows more quickly.
Banks vary the compound frequency so that it ranges from daily, monthly, quarterly, or annually. The more frequent the compounding, the more money you will earn. Many banks compound daily or monthly, and that may make a more noticeable difference at higher rates.
You may find some trade-offs with some banks offering higher APY with higher initial minimum deposits and ongoing balance minimums you may need to maintain.
Drawbacks of A Money Market Account
1. Minimum Balance Requirements
Money market accounts often require an initial minimum balance higher than standard savings banks or money market mutual funds. Additionally, you may need to maintain the balance to avoid charges or fees. The minimum balance requirements vary by bank, and you can review these requirements before opening an account.
Some banks may have no minimums or a small requirement of $1,000, while others may want a minimum of $10,000. Typically, the higher the minimum balance, the higher return on your account and likely fees for maintaining the balances.
2. Inflation Risk
Inflation is a concern for financial markets, impacting your money in the future. If you are earning 1% on your money market return and inflation is running at 3%, you are losing 2% on your money market account. However, as the Fed raises interest rates, money market accounts will command higher interest rates, keeping better pace with inflation.
3. Current Low-Interest Rates
Although there are expectations for higher interest rates, money market rates are currently at low rates, not leaving much room for interest income.
4. Watch Those Fees
Banks are known for their fees. They may charge monthly fees or if you fail to maintain the minimum or write too many checks. Read the fine print carefully and understand the bank’s fee structure details. Fees impact your returns so understand the bank’s rules.
5. Withdrawal Restrictions
Banks are subject to Regulation D limits for savings accounts, including money market accounts. They have withdrawal and transfer guidelines for using debit cards or checks six times per month. Individual banks may differ when you make excessive withdrawals. There are no limits if you go to the bank or ATM to make transfers or withdrawals.
Consider These Questions Before Opening A Money Market Account
What are the applicable interest rates you will earn, fixed or variable, and compounding frequency?
Are there minimum deposits and ongoing minimum balances to maintain and fees to pay?
Can you link to a checking account or debit card at the respective bank?
How convenient are the deposit options such as using a mobile app, bank, ATM, or mail?
What are the withdrawal and transfer restrictions, and does going to the bank or ATM count toward the monthly limits?
How do you define excessive withdrawals, and what are the consequences? Are there any exceptions like emergencies where I may have flexibility?
What potential limitations are there in accessing my money?
What fees or penalties does the bank assess on money market accounts, and are they avoidable?
As interest rates rise, money market accounts will become more appealing, and keep better pace with inflation which doesn’t look like it is abating any time soon. Consider MMA with higher rates than ordinary savings accounts, and use them for savings goals rather than for many transactions.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.