Many people wonder what to do with the money they have put aside:
Invest it or keep on saving it?
However – we can always do both by putting the extra cash into a money market account (MMA).
These accounts are offered by banks and credit unions and are very similar to deposits and savings accounts. However, they provide investors with higher interest rates, therefore you can generate higher yields.
This article will show you how these accounts work, what their pros and cons are, how to manage them as well as some other important things to know. Let’s get straight to business.
How they work
As mentioned in the intro, their mechanism is very similar to one of savings accounts.
MMAs tend to offer higher interest rates than savings accounts. This means that the more money you put, the more you will earn. Money market accounts work as the following:
- First, you set up an account at a bank or another financial institution
- The bank will pay you interest because you have put your money into their account; they are paying you for using your cash. The bank, consequently, will lend this money to people at an interest rate.
- You can withdraw your money whenever you want (check the section “How to manage an MMA” for more details on that)
- The bank pays you a compound interest (more details in the section “How is interest calculated)
The Pros and Cons of Money Market Accounts
Advantages of Money Market Accounts
Let’s begin with the benefits MMAs offer:
Higher Interest Rates, Higher Yields
Money market accounts tend to pay higher interest rates than other similar accounts.
In addition, the rate they offer is compound, which means that the more your balance grows, the more money the bank will pay you.
These accounts are considered safe and low-risk investments since they are protected by the US government.
- If you have a bank account, it will be insured by the Federal Deposit Insurance Corporation (FDIC), which means that even if the bank goes bankrupt, your money will be restored to you. There is a limit, though– $250,000. If you exceed this limit, the money above the mark will not be insured.
- If you have a credit union account, it will be insured by the National Credit Union Administration (NCUA), which just like the FDIC is a government agency.
For many people, easy access to their money is very important, understandably. You can easily withdraw money from cash machines or write checks and make transactions.
Keep in mind that there is a limit on these operations.
Disadvantages of Money Market Accounts
Everything has its drawback including money market accounts.
Higher Minimum Balance Requirement
MMAs usually have higher minimum balance requirements. This is the minimum amount of money your bank wants you to have in the account. They usually range between $1000 and $2,500.
For instance, Bank of America requires $2,500. If you fail to meet that requirement, you will be fined. In comparison, most savings accounts are free of charge with regard to this requirement.
Limited Number Of Withdrawals
The number of withdrawals you can make is fixed. If you exceed this number, you will have to pay a fee. Sometimes the fees are higher than the interest you have generated on your money.
Relatively Low-Interest Rate
Compared to savings accounts, the interest is higher but compared to other investments, say bonds, the interest rate is significantly lower.
For instance, the average return from investments in the stock market is 10%. A money market account can generate approximately 6% a year. In the long run, this difference can be crucial.
Inflation always poses a serious risk to investments that generate lower interest rates.
Basically, inflation decreases the value of money in the future. In 1999 $2,000 was different than $2,000 now. For instance, your MMA has an annual interest rate of 2.5%, but at the same time inflation in the country is $3.4.
Even though you can access your money in the account, there will be a limit. By law, you cannot make more than 6 payments a month using your MMA. Bear in mind that this number might be even lower depending on your bank (union). Definitely, you will not have the flexibility you can have using a checkbook or a debit card.
How is the Interest Calculated in MMAs
As I explained earlier, the interest an MMA pays is compound. Your bank will compute it every day and distribute monthly.
A compound interest is the money a bank (credit union) will pay you on the original amount of money as well as on the interest you have earned. For instance, if you put $5000 in a money market account at 6% annual interest rate, for the first month, the interest you earn will be $25. 5000×6%=25.
For the next month, however, the interest will be calculated on $5,025. You can see how your money grows exponentially, and the amount of interest grows by the day. This is particularly lucrative if you put large amounts of money into the account.
If you put $100,000 in a money market account for ten years at 5%, the whole value which you will receive at the end of the term will be $164,000. This is quite impressive, isn’t it?
How To Manage Money Market Account
As you already know, as most savings accounts, you can withdraw money at all times. However, if you exceed the number of “free” withdrawals, you will have to pay a fee. So, be careful and know how many times you can withdraw money. Usually, for each withdrawal above the permitted number, you will pay a fee of $10 (depends on the bank, though).
In addition, there are some fees you owe in case you don’t have the minim required balance in your account. Again, depending on the issuer, you will have to pay a fee of between $5 and $10.
Before you purchase a money market account, compare different banks and offers for the best terms for you and read the fine print.
When you set up an MMA, the bank will give you a register. This is something like a diary, where you will record all your transactions, withdrawal, balances, pretty much everything. You can use your register to track your money and know what’s happening.
In addition to that, your bank will send you monthly a statement of your account. This statement will show you your balance during the month, the transactions you have made and the interest you have earned.
If you want to make sure everything runs smoothly (yes, banks make mistakes!), you have to “reconcile”. This is a process of comparing the data in your register with the data on your monthly statement. If there is a mistake, try to correct. Either you or your bank has made a mistake.
Money Market Account vs Money Market Funds
These two things are commonly mistaken and confuse people. Let me compare them.
To begin with, an MMA is a savings account as you already know while a money market fund is a type of mutual fund. The latter is an investment in a fund, not an account at a bank. Therefore, you will not have an FDIC or NCUA protection.
It’s good to mention that MMFs (just like other mutual funds) might invest in a variety of assets, including government bonds. Having said that, including the fact the government doesn’t protect them, MMFs carry greater risks. Money market funds offer a greater variety than MMAs, and also can have some tax benefits.
Both MMFs and MMAs depend on various factors, including inflation or recession. The latter affected both negatively. The recession did not hit money market accounts as badly as it did money market funds.
Who can benefit from an MMA?
Having discussed all the pros and cons as well as the way MMAs function, let’s mention who these investments are most suitable for:
- Investors who have spare money and want to play it safe and secure
- People who want to have an easy access to their savings
- Investors who can afford to keep the minimum required balance
- You are a person who doesn’t need to write too many checks from their MMA
- You have a money market account in the same bank where you keep other accounts. This will make the process of making transactions very fast and very easy.
Money market accounts are a very simple and easy to handle investment opportunity. Even though they have some drawbacks, it’s safe to say that the offer some great perks.