What is the difference between money market funds and CD’s?

A money market fund is a mutual fund which invests in safe and secure investment options like corporate paper, government bonds and securities to offer a low return high safety investment vehicle for investors. A CD is a deposit account offered by banks and has a fixed tenure of investment and a certain rate of interest. Although both are traditionally conservative investments, yet there are certain areas in which they differ widely from each other.

Rate of return

A CD has a fixed rate of interest at which the bank will repay your principal amount at the end of the CD’s tenure. A money market fund, on the other hand, will not be able to guarantee a certain yield at the time of investment. Its returns would depend on the performance of the corporate paper or government securities it has invested in, and the portfolio allocation among various scripts.

Insurance

Since a CD is basically a bank deposit, hence it is ensured by FDIC. This means that even if the bank where you have a CD closes down due to some reason, your investment is protected. But a money market fund enjoys no such protection. If the underlying investments of such a fund go into negative returns then the net asset value of the fund also will fall below $1. Having said that, it is also true that in the history of money market funds, there have been only two occasions when the buck have been broken and the net asset value has gone below $1.

Tax Liability

A money market fund can offer both options to a customer – a tax free fund with lower yield, or a taxable fund that offers higher yields. But a CD is taxable at source or the individual can choose to pay the tax on the returns on a CD while filing his annual income tax return.

Liquidity

This issue is more of a similarity than a difference between money market funds and Certificates of Deposit. Both offer easy liquidity to the customer. But this comes at a price. For a CD, a premature withdrawal fee is payable, which is deducted from the proceeds of the CD. While withdrawing a money market fund, an exit load could be charged if a certain period has not yet elapsed since the investment was made.

The investment pattern, risk appetite, age and annual income of an investor should decide whether he should go in for a CD or invest in money market funds, and this choice would also depend on the rates and other terms offered by each product.