Money Market or CDs?

With record gas prices, rising food costs, and stagnant (or declining) salaries, it’s difficult to save money these days. If you’re like me, when I come across extra money to sock away, I want it to be accessible, secure and earning the highest interest rate possible.

I’ve found that both money markets and certificates of deposits are great options to consider for the investment-weary, although interest rates have been frustratingly low for the past several years. There are, however, important differences that will determine which is right for you.

Here is a short primer on both, including the pros and cons.

Certificates of deposit (CDs)

Certificates of deposit, or CDs, tie up your money for a specified length of time, ranging from a few short months to several years. During this time, your money typically earns a fixed interest rate that largely depends on the length of the CD term. The longer the money is locked away, the higher the rate you will receive.

If you withdraw your money before the CD maturity date, there is a penalty in terms of the number of days of interest — typically 60 days on the low end up to 6 months on the high end. In general terms, you want to avoid early withdrawal because that penalty will eat into your earnings. And if the penalty exceeds the amount of interest earned as of the date of withdrawal, the difference may be deducted from your principal.

The upside is that you can determine your earnings with CDs beforehand, so you’ll know exactly what you’re getting. Also, this is a very safe investment choice. Your money is insured up to the current FDIC insurance limits. However, those who opt for longer maturity time frames will also lose access to this money for a long time period, and will face interest rate risk.

One of the most important factors in purchasing your CD should be interest rate. This amount varies depending on the current interest rate, how much money is being invested, the maturity length of the CD and the bank you are using. Another important factor are the penalty terms. If the penalty is low enough and the rate (vs. your alternatives) is high enough, you might even consider using a long-term CD as a short-term investment vehicle.

When CD shopping be sure to pay close attention to the terminology — especially distinctions like annual percentage yield (APY) vs. annual percentage rate (APR). The number that you’re ultimately interested in is the APY, which tells you the rate at which your earnings will grow each year. APR doesn’t include the effects of compounding, so you’ll have to be sure the other terms are equivalent if comparing based on APR.

As an example, if you invest $5, 000 in a CD that’s paying 5% APY, then you will earn $250 in your first year. And then the next year, you will earn 5% on the new balance of $5, 250 — and so on.

In addition to banks, credit unions and full-service brokerage firms sell federally-insured CDs. Since brokers shop the entire country for high yields, brokered CDs may be a good option, though you’ll need to be careful to be sure you don’t exceed FDIC limits (if you buy through a broker, the CD still counts against your FDIC limit at the issuing bank), and there may also be limitations on your ability to withdraw your funds early.

There are also other flavors of CDs, like equity-indexed CDs, which base their returns in part on the performance of the stock market. Minimum investments are often higher for indexed CDs, and you are typically required to hold them to maturity, with no option for early withdrawal. In addition, your upside potential is typically capped in return for the relative security that a CD can offer. This means that, even if the stock market takes off, you will only enjoy a limited gain.

Money markets

There are two main types of money markets. Money market deposit accounts (MMDAs) are a cross between a checking and a savings account. Although earning more than interest-bearing checking accounts, you are restricted in the number of withdrawals each month. Offered by banks, the deposit is insured by the FDIC, so both the principal and interest are 100% guaranteed.

In contrast, money market mutual funds (MMMFs), are typically offered by mutual fund families and are not FDIC insured. These funds offer market-based interest rates and the average maturity of securities is 90 days or less. These funds typically seek to maintain a stable value of $1/share, with dividends being paid out monthly. There are, however, no guarantees and the lack of FDIC protection means that MMMFs are riskier than MMDAs and other bank accounts.

Although money market accounts are more accessible than CDs, banks are required to limit you to six withdrawals per month, and they may also require a steep minimum balance or they will charge you a monthly service fee. The interest rates associated with these accounts is also often determined by the amount of money deposited. The more money put in, the higher the rate of return.

Making the Decision

When choosing between a CD and money market account, it’s best to first determine your needs. Will this money be saved for short-term or long-term expenses? If you’re looking to use it for a vacation, car repairs, or a home expense within the next six months or less, a money market would be your best bet.

For rainy-day or more long-term savings, such as to cover expenses during a job loss or for a new house, a CD may be a better choice — especially if create a ladder of CDs with varying maturities such that you’ll have one coming due every 6-12 months.

Because CDs and money market funds are both safe short-term investment options, both are worth considering for money you don’t want to tie up or risk in the stock or bond markets. Just be sure to do your homework to see which banks offer the best rates and terms before committing to an account.