Comparing Money Markets to CDs

Money markets and certificates of deposit (CDs) are not one and the same.

In the reality television show House Hunters, property seekers view three homes and select one to buy. The decision inevitably comes down to the same thing: the buyers can't afford every feature they want, so they must pick the best compromise. If you want a safe investment for you cash, you face a similar dilemma; but there are only two factors to balance-yield and liquidity.

No changes allowed

The certificate of deposit, or CD, is a time deposit that guarantees you a fixed rate of interest until a specified maturity date. This rate will be much higher than that of a regular savings account, mainly because you're agreeing to keep your money on deposit until the CD matures. You could take your money out early, but you would be penalized.

CD rates tend to follow current and projected interest rates. When interest rates on deposits are expected to rise significantly, longer-term CDs will have higher rates than shorter-term CDs. From the CD issuer's perspective, this encourages investors to lock in their funds now before rates shoot up. Alternatively, when rates are expected to decline, short-term CDs pay higher rates. That's because issuers are reluctant to lock in high rates for the long-term now, when they can pay lower rates later.

Versatility the name of the game

Money market deposits are far more fluid. There's no time requirement for your deposit, and you have access to your money when you need it. You'll likely have a checkbook for the account, but you'll have to use it sparingly. The account will only allow you to make a limited number of transactions, and write a limited number of checks each month.

The bank invests your deposits in safe, short-term debt and deposit products, such as savings bonds and CDs; the money earned from these instruments is used to pay your interest. The yield on your money market deposit is subject to change, and may be dependent upon your account balance, with higher balances earning better yields.

Weighing the options

CDs typically offer higher rates than money markets. But with this higher rate comes reduced liquidity and a certain level of interest rate risk. As a quick primer, interest rate risk is the possibility that your CD will become less appealing due to changes in market interest rates. Imagine locking in a 5 percent CD for five years, only to see market rates rise to 6 or 7 percent during that period. You might be kicking yourself for not waiting longer to lock up your funds.

Money markets give you the versatility of liquidity, but at a lower interest rate.

Which is best? For an emergency fund, the money market's liquidity probably wins out. When you don't need the cash right away, go for the high-rate CD. If you still aren't sure, get one of each: that might give you the yield and liquidity balance that you need.