Money Market Accounts or CDs: Which Investment Is Better?

Money market accounts (MMAs) and certificates of deposit (CDs) may seem interchangeable. They're both bank products that offer interest and peace of mind, as they're FDIC-insured. However, choosing between them ultimately depends on the specific objective you have for the cash and your need for liquidity. Understanding the differences between the two and comparing the best CD rates with the best money market account rates are two keys to determining which is the most appropriate vehicle for your needs.

Generally, there are several reasons to keep a portion of your assets in cash or these types of cash equivalents. A well-conceived financial plan dictates that you maintain an emergency fund worth three to six months of your living expenses. You can use MMAs and CDs to diversify your investment portfolio or fund a short-term goal.

How Money Market Accounts Work

An MMA is a type of mutual fund that invests in short-term, interest-bearing instruments to generate a variable yield while preserving principal. MMAs may deliver interest rates that are higher than savings accounts, but they often require a higher minimum deposit. Some accounts also require a minimum balance to receive the highest rate.

The interest rates on MMAs are variable, which means they rise and fall with the overall interest rate market. Most MMAs come with limited check-writing and balance-transfer privileges. Federal regulations used to limit the number of "convenient" withdrawals from MMAs to six per month, but that policy was suspended amid the COVID-19 pandemic. Nevertheless, financial institutions may impose their own withdrawal limits.

There are important differences between money market accounts offered by banks and money market funds offered by brokers or mutual funds. Money market funds are similar to MMAs, except they aren't insured by the Federal Deposit Insurance Corp. (FDIC). Money market funds are typically offered as an option in 401(k) plans. Since 2016, these funds have had to be invested in U.S. Treasury or government bonds rather than corporate or municipal bonds. The change came courtesy of the U.S. Securities and Exchange Commission (SEC) to enhance liquidity and quality requirements.

How Certificates of Deposit Work

CDs are best described as timed deposits that provide a fixed interest rate tied to a maturity date. A lengthier deposit period may result in a higher rate of interest, although this depends on the bank. CDs are issued with maturities that range in length from one month up to 10 years. The best CD rates may rival or beat other deposit accounts.

With traditional CDs, banks charge a penalty for withdrawing money prior to the maturity date. Some banks now offer no-penalty CDs that allow you to withdraw your money without that penalty, but you are likely to receive a much lower interest rate for that privilege. Other types of CDs allow you to withdraw only interest without penalty.

When an MMA Is Better Than a CD

Generally, an MMA is better when you have or may have an immediate need for cash. If your car engine blows up, you wouldn't want to pay a penalty for prematurely withdrawing money from a one-year CD. If you have a near-term purchase planned, such as a new car or major appliance, an MMA provides greater flexibility from a liquidity standpoint.

MMAs may also be a better choice in an environment of rising interest rates. Banks periodically adjust the yield on MMAs, offering the opportunity to earn more on your money as interest rates rise. Traditional CDs, by comparison, have fixed interest rates. However, you can achieve the same effect by investing in short-term CDs and rolling them into higher-yielding CDs as they mature.

When a CD Is Better Than an MMA

CDs may offer higher yields than MMAs, although this depends on the issuing bank. A longer maturity date might come with a higher interest rate. If you won't need the money, you could look for the best rate with the longest term, and lock that in. CDs are often used to fund goals within a 10-year time frame, when you may not want to risk the price fluctuation of market-based options, such as a stock mutual fund.

Although investing in longer-term CDs can secure a high fixed interest rate, it would be a disadvantage during a period of rising interest rates. If you think that interest rates will rise for a period of time, you would be better off investing in shorter-term CDs. Some banks offer variable-rate CDs with annual percentage yields (APYs) that increase as interest rates rise, but their initial yields tend to be lower than those of traditional CDs.

You could also employ a CD ladder strategy to balance your need for liquidity with obtaining higher yields. You could, for example, invest equal amounts in one-, two-, and five-year CDs. When the each CD matures, you can decide to either withdraw the money or roll it into a new CD. This lets your money grow at fixed interest rates while maintaining a degree of liquidity and giving you periodic access to your funds.

Frequently Asked Questions (FAQs)

The Bottom Line

Whether a CD or an MMA is better for a given investor depends on their time horizon and risk tolerance. CDs may pay higher interest than MMAs, especially for longer maturities. Both types of accounts are safe, as they carry FDIC insurance up to $250,000, but MMAs are more liquid and don’t involve early withdrawal penalties.