Rising Tides Lift All Boats
Interest rates are on the rise, and while this poses challenges for some investors and asset classes, it also presents opportunities. As the Federal Reserve raises rates in response to inflationary pressures, short-term investment vehicles become increasingly attractive. This means that, for the first time in over a decade, there is a lot of reason to make sure the balances you're keeping in your checking account are as low as possible. If you have anything north of a few thousand dollars of excess cash sitting in bank accounts, you should strongly consider moving it to a money market fund.
As of this writing, the national average interest rate on a bank savings account is 0.37%. That's roughly $37 interest per year for every $10,000 you hold; peanuts. It goes without saying that this is much less than inflation, but it's also much, much less than you can earn elsewhere.
Banks also offer Money Market Accounts (MMA) and Certificates of Deposit (CDs) for customers looking to increase yield. MMA's currently return a whopping average 0.54%. Hardly any better than the savings account. CDs can return a much higher rate, but require you to commit the money to the bank for long periods of time (years, if you want a decent rate), sometimes with steep penalties to get the money back before maturity.
In comparison, a prime Money Market Fund (MMF) is currently yielding 4.69% (for example, SWVXX), well over 10x the return in a bank account. Even on just $5,000 that difference amounts to about $20/month in extra interest income. For anyone sitting on a lot of cash, the different in interest income may be very substantial.
What is an MMF?
Banks use savings accounts primarily as a stable source of funding for their lending activities, offering account holders a modest interest rate in exchange for the ability to access their funds immediately, as well as security that the principal will never go down, and that even if the bank should fail the FDIC will insure deposits up to $250,000 per account. This interest rate banks offer on savings accounts is kept low to minimize the bank's costs, which is a polite way of saying to maximize the bank's profits. The bank is using your money to generate far more income for themselves through their lending and investment activities -- this is literally the business of banking. In lower rate environments it doesn't matter as much, but now it does.
Enter Money Market Funds
Money Market Funds are not bank accounts. They are investment accounts where your money is used to buy into a basket of underlying securities, things like government bonds, corporate bonds, and repurchase agreements. MMFs are very highly regulated, and the underlying securities need to be of certain credit quality and maturity profile such that the fund is well diversified and retains sufficient liquidity to honor all withdrawals.
MMFs are investments, and carry credit risk. They are not guaranteed or insured by the FDIC. When you buy into an MMF, what you are buying are the underlying investments. If the MMF sponsor goes bankrupt your money is still secured by the underlying investments in the funds. It is technically possible for an MMF to lose value, but it is extremely rare. Since the inception of MMFs in the 1970's it has only happened twice. Most recently, the Reserve Primary Fund did this in 2008 after having made short term investments in Lehman Brothers debt that went to zero. Even in that extreme case, that single MMF only lost 3% of its principal. No other MMFs across the industry lost principal during the financial crisis. So that said, MMFs are very, very safe.
MMFs also provide easy access to your money. In most cases you can have your cash back the next day. (Realistically, you can sell the MMF in one day, and then it'll take one or two more days to move back into your back account).
MMF's are extremely easy to purchase. You can very likely buy them using your existing broker platform. Below are a few examples:
- Schwab Value Advantage Money Fund (SWVXX)
- Fidelity Money Market Fund (SPRXX)
- Vanguard Federal Money Market Fund (VMFXX)
- Invesco Government Money Market Fund (INAXX)
Money Market Funds are finally paying out real money now that the Fed has moved us out of a zero interest rate environment. Make sure you're adjusting your cash strategy appropriately or you could be leaving a lot of money on the table.