Exploring the difference between Savings Accounts, CDs, and Money Market Accounts
Chances are you’ve heard of savings, CD, and money market accounts but you may not be familiar with the advantages and disadvantages of each. While there definite differences between the three types of accounts, the have several characteristics in common as well including the following:
- FDIC Insured: These accounts are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 each (at the time of this writing). This means that if the bank goes out of business while holding your funds for any reason, you will be reimbursed for the full amount (including principal and interest earned) without losing any money.
- Low-risk investment: As far as investments go, all three accounts are pretty much the lowest risk you can get. Interest rates are clearly defined and, barring any bank penalty fees, you cannot lose principal. This makes these investments ideal for cash holdings and emergency funds since they are extremely safe and highly liquid.
- High Liquidity: An investment has high liquidity if it can be withdrawn easily in cash. These three options represent some of the most liquid investments available anywhere. Typically you can receive your cash within 1-7 business days.
Just about every brick-and-mortar bank offers these products and online banks are increasing in popularity as well. If you have some cash savings that you wish to invest with the minimum amount of risk, these are the most viable options out there.
The Emergency Fund
An emergency fund is basically a cash reserve that can support you financially during… well… emergencies. It is recommended by nearly every financial planner to have an emergency fund however the actual amount of this fund can vary depending on who you talk to. Generally it is recommended to have six months of income in reserve to handle situations such as illness, job loss, unforeseen large expenses (home/car repair), etc. Six months of income is a lot of cash to have not working for you which is essentially how these products came to be.
Most people currently have or at least know someone that has a savings account. These are the most popular and easiest accounts to setup and are offered by virtually every bank. Savings accounts are simply accounts where the bank pays a small amount of interest for you to maintain. The bank makes money by lending these funds out in the form of loans to other bank members and they pass some of these profits onto the savings account owner; you.
Savings accounts are the most liquid interest bearing account you can get meaning you can move money in and out with little or no delay. Some banks have hidden fees as well such as minimum balance and maximum transaction limits. Make sure you understand the fees associated with your savings account, one bank fee can negate several months of savings interest.
Money Market Account
A Money Market Account (MMA), or money market direct deposit account, is essentially the same thing as a savings account from the customer’s perspective. The difference is in the types of investments the bank can make with these funds. With savings accounts, banks are restricted to loans made to individuals who need to borrow money at a set interest rate. These loans are much safer but aren’t as profitable for the bank. With a money-market account, the restrictions get a little looser. The bank may invest in products outside of the bank itself such as bonds, treasury notes, and even CDs. Because these investments offer a higher rate of return, these profits are once again shared with the account holder.
The only difference between an MMA and savings account from an account-owner’s stand-point is liquidity. Money market accounts are not quite as liquid as savings accounts. You may need to wait a few (typically no more than 7) business days to make a withdrawal and you are much more limited in the number of transactions allowed on a monthly basis.
If you do not usually make monthly withdrawals from your savings account, then a money market account is a much better way to go. The interest rates are much higher and you are still able to access money relatively quickly. Some money market accounts, especially those offered by online banks, are even providing check books and ATM debit cards for faster withdrawals.
Certificates of Deposit (CDs)
A Certificate of Deposit or CD is another low-risk, interest bearing account offered by most brick-and-mortar and even more online banks. CDs gain a predetermined amount of interest of a set period of time and offer higher interest payments than savings and money market accounts. The catch is that you have to leave funds invested for the full term in order to collect the interest. If you invest in a CD and have an emergency, you can still make an early withdrawal. The difference is that you will have to forfeit some or all of the interest the account would have earned if it was deposited for the full term. This sounds confusing but it’s really straightforward. Here’s an example of CD options you could choose from:
As you can see, the longer of a term you commit to, the higher the percentage yield. A CD is not always the best option when compared with a money market. Some of the lower-end CDs (less than 1 year) can sometimes return less than a traditional money market. The difference is that CDs are locked into these interest rates whereas money markets accounts can move up and down. Another reason for choosing low-end CDs is if you are in the process of creating CD ladder. CD Laddering is a great way to maximize your interest payments while minimizing the intervals between when CDs mature. This sounds harder than it is and you can find more information about this process by going to: http://www.consumerismcommentary.com/how-to-create-the-ultimate-certificate-of-deposit-cd-ladder.
Which account is right for me?
Deciding which accounts and how much to put in each is largely a matter of opinion. The important thing to remember is that savings vehicles are not checking accounts. Many people use savings accounts and other interest-bearing accounts as a glorified checking account, making frequent withdrawals and deposits. Not only do you run the risk of bank fees by doing this but you also miss the point of saving which is to only use these funds in case of an emergency. If you expenses ebb and flow on a monthly basis, keep some extra money in your checking account to cover these peaks and valleys. Dipping into any savings account should be for emergencies only and this concept is too often overlooked.
You should consider diversifying your cash account among the options listed in this article. How you want to diversify is really up to you and little liquidity you’re comfortable with. Going back to the 6-month emergency fund, here is an example of diversification. For the sake of this example, we’ll assume John Doe has a monthly income of $4,000.
|Account||Months of Income||Amount|
|Savings Account||1.5 months||$6000|
|Money Market Account||2 months||$8000|
|CD Ladder||2.5 months||$10000|
This is an example of how you can balance out liquidity and interest earnings to meet your specific needs. Talk to your banking official or financial advisor to figure out a system that works best for you. The good news is that if you follow the rules of these accounts, you can’t really go wrong. You may not earn as much by using a savings account over a CD Ladder but you’re not losing money either. A cash reserve is an integral part of personal finance and these accounts are useful tools to maintain your emergency fund.