If you’re saving money for a near-term goal — like buying a house, taking a trip, or building an emergency fund — the priority should be keeping the money safe. The last thing you want to do is invest it in something risky, only to find that the money isn’t there when you need.
But it’s also nice to earn at least a little return. After all, you’re working hard to save that money and it would be nice for your money to return the favor and work a little for you as well.
The good news is that there are a few different ways you can accomplish both goals. Savings accounts, CDs, and money market mutual funds all offer the opportunity to get a little return while also keeping your money safe.
But which one is the best choice for your needs? This article breaks down the pros and cons of each so that you can make a smart decision.
The Basics of Savings Accounts, CDs, and Money Market Mutual Funds
Before diving into a comparison of each of these savings options, let’s quickly get on the same page about what each one actually is.
Savings accounts are offered by banks and provide three main benefits:
- The promise that your account balance will never decrease.
- A small return in the form of the interest rate.
- FDIC insurance that guarantees your account will never lose value (up to certain limits).
While the interest rate can and will move up and down based on the federal funds rate, a savings account is still one of the safest and steadiest places to keep your money. And if you use an online bank, you can earn a pretty reasonable return.
Certificate of Deposit (CD)
CDs are also typically offered by banks, and while they share some similarities with savings accounts, they also have a few unique features:
- They offer a fixed interest rate for a set period of time.
- If you withdraw your money before that set period of time is up, there is typically a penalty.
- Because your money is less accessible than it would be within a savings account, CDs typically offer slightly higher interest rates.
- CDs issued by banks are also covered by FDIC insurance.
While those are the basic characteristics, different banks offer CDs with all sorts of unique features, so it’s always worth shopping around.
Money Market Mutual Funds
Money market mutual funds are offered by investment companies, not banks, and they operate much like stock and bond mutual funds in that they hold many different investments.
The key with money market mutual funds is that the investments they hold are generally all high-quality, short-term debt, which makes them function a lot like a savings account. The key features include:
- Returns that vary with market interest rates, but that are comparable with savings accounts and CDs.
- The potential for tax savings, depending on the type of money market mutual fund you choose.
- Because they are investments, there is the possibility that they can lose some value.
- While they are not covered by FDIC insurance, they are covered by SIPC insurance, and some investment companies purchase additional insurance coverage as well.
While money market mutual funds don’t pay an interest rate in the way that savings accounts and CDs do, you can look at the fund’s SEC yield for an estimate of what it might return.
Savings Accounts vs. CDs
The main reason to consider a CD over a savings account is the potential to earn a higher interest rate. For example, as of this writing, Ally Bank is currently paying 1.70% on their savings account and 2.10% on their 12-month CD.
There are two significant downsides that you have to accept in order to get that higher interest rate though.
The first is the fact that you’ll have to pay a penalty if you want to take money out of your CD before the set time period has passed. That penalty varies from product to product, but in many cases will come in the form of a forfeit of interest, which would mean that your actual return was less than your expected return.
The second is the fact that, in most cases, a CD’s interest rate is fixed while the interest rate on a savings account can change over time. In a rising interest rate environment, which many experts believe we are currently in, that could mean that you might earn more in a savings account over time, even if the interest rate is smaller right now.
Still, a CD can make a lot of sense if you’re relatively sure you won’t need the money for a certain amount of time, the potential penalty for early withdrawal is small, and the difference in interest rate is significant.
For example, let’s say that you have $20,000 set aside for a down payment on a home that you plan on buying when you move in a year. If you put that money into Ally’s 12-month CD instead of their savings account, you’re looking at earning an extra $150 with very little risk.
If, on the other hand, your timeline is less certain, you may be better off going with the savings account and avoiding the potential penalty.
One thing to watch out for when choosing a CD is that a longer term doesn’t always lead to a higher interest rate. Again looking at Ally Bank’s CD rates as an example, their 18-month CD is currently paying a little less than their 12-month CD. The benefit there is that you have that interest rate locked in for a longer period of time, which would be helpful if interest rates fall. But the downside is that if interest rates rise, you may miss out for an additional six months.
Savings Accounts vs. Money Market Mutual Funds
Money market mutual funds have two potential advantages over savings accounts.
First, you may be able to get a slightly better return. For example, the SEC yield on Vanguard’s Prime Money Market Fund is currently 2.37%, compared to the 2% interest rate on Ally’s savings account.
Second, you may be able to get a better after-tax return by choosing the right money market mutual fund. For example, if you use a money market mutual fund that invests exclusively in US Treasurys, your earnings will be exempt from state income taxes. If you use a money market fund that invests exclusively in municipal securities issued by your home state, your earnings will be exempt from both state and federal taxes.
Of course, there is some risk involved with these funds when compared to savings accounts.
The biggest risk is the lack of FDIC insurance, which means that your money is not protected against the loss of value. The SIPC insurance that covers these funds does protect you against bankruptcy, but it’s important to understand that your account balance can fall.
Another risk, especially if you’re trying to maximize your after-tax return, is that by concentrating too much on one type of investment (e.g. municipal securities issued by your home state), you’re losing some of the benefits of diversification and exposing yourself to greater risk of losing value.
And finally, while not exactly a risk, the fact that your money is held at a brokerage instead of your bank means that you may not be able to access it as quickly. Whereas you can typically withdraw at least some money from a savings account immediately, or transfer it to your checking account, it may take a day or two to get it from your brokerage account to your bank.
At the end of the day, though, money market mutual funds fare generally incredibly safe. And if you live in a high-tax state, the ability to get a little bump in after-tax return may be worth the investment.
Get What You Can Without Overthinking It
Savings accounts, CDs, and money market mutual funds can all be used to earn a little return while keeping your money safe. And while there may be ways to eke out a little extra return here and there, the reality is that the three options are more similar than they are different.
As long as you find an approach that’s safe, convenient, and earns you a competitive return, you’re doing just fine.
Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families.
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