Money Market vs. Certificate of Deposit

how certificates of deposit work

By Joshua Kennon. Investing for Beginners Expert

Thanks to his straight-forward approach and ability to simplify complex topics, Joshua Kennon's series of lessons on financial statement analysis have been used by managers, investors, colleges and universities throughout the world. "If an investment idea takes more than a few sentences, or cannot be explained to a reasonably intelligent fourth grader, you've moved into speculation," Joshua insists. "Whether you're dealing with a public company such as McDonald's, or a private company such as Chanel, these are the types of firms that are easy to understand. You know where the sales originate, what the costs are, and how profits are generated. These are the types of enterprises that aren't going to cause you to wake up in the middle of the night, breaking into a cold sweat because of the sub-prime crisis or esoteric securities trading in illiquid markets. That's a huge advantage to growing your wealth. Focus on what you know, pay a fair price, and invest for the long-term.

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In the Left Corner: Certificates of Deposit

Certificates of deposit (or CDs for short) are debt instruments issued by banks and other financial institutions to investors. In exchange for lending the institution money for a predetermined length of time, the investor is paid a set rate of interest. Maturities on certificates of deposit can range from a few weeks to several years, with the interest rate earned by the investor increasing in proportion to the time his capital is tied up in the investment under most yield rate environments.

Pros: The investor can calculate his expected earnings at the outset of the investment. Certificates of deposited are FDIC insured for up to $250,000 and offer an easy solution for the elderly who desire only to maintain their capital for the remainder of their life.

Cons: If the investor opts for a longer maturity and, thus, higher rate of interest, he will lose access to his funds and forego alternative uses of his capital.

In the Right Corner: Money Market Funds

Money markets, on the other hand, are very different.

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First, it is important to understand the difference between and

FDIC insured money market account  at a bank and a non-FDIC insured money market mutual fund  offered through a brokerage firm.  They are not the same thing.

A money market account at your bank offers many of the benefits a certificate of deposit does, only it has the added feature of check writing, in most cases.  If you have a larger balance, you might be able to get a slightly higher yield depending on the rates being paid at the time, and you won't have to wait for certain maturity dates to get your hands on your principal.  On the flip side, withdrawals are often limited to a set contractual amount (e.g. no more than 4 withdrawals a year).

Money market mutual funds, in contrast, are pooled mutual funds focused on acquiring portfolios of government t-bills, savings bonds. certificates of deposit, and other safe and conservative financial instruments.  The portfolio manager strives to keep the fund at exactly $1.00 per share so it appears to work like cash, even though it's not.  In times of severe stress or manager error, a money market mutual fund can theoretically "break the buck ", though it has been a very rare event, historically.

Pros: Depositing money in a money market is as easy as depositing cash into a savings or checking account. Cash is immediately available for alternative investments if you change your mind and want to put your capital to work elsewhere, in stocks, buying real estate. or even spending it.

Cons: Some financial institutions place a limit on the number of checks that can be drawn against the account in any given month. The rate of interest is directly proportional to the investor's level of deposited assets, not to maturity as is the case with certificates of deposit. Hence, money markets are disproportionately beneficial to wealthier investors.

The Verdict

Although both can be useful, for those who need access to their capital and / or have much higher cash balances, money markets are often the superior choice.  For those who want to time maturities to certain events or benefit from a willingness to lock away savings for a long period of time, certificates of deposit are often the better portfolio selection.

Source: beginnersinvest.about.com

Category: Bank

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