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WTF: Money Markets

photo by woodleywonderworks via Flickr.

Money markets can be confusing. What exactly are they? What exactly do they do? Are they boring enough to lull me to sleep atop my keyboard?

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What The Finance is your “dummies guide” to understanding the basics of everyday financial topics. 

While this last question will be yours to find out (if the answer is maybe, then “droolproof” your computer accordingly), what money markets are and what they do can be answered with some simple explanation.

But first things first: what is the definition of a money market?

“Money markets are for borrowing and lending money for three years or less. The securities in a money market can be U.S.government bonds, Treasury bills and commercial paper from banks and companies.” – The Free Dictionary

So how are money markets applied in the real world? This question is best answered through two lenses–money market funds and money market accounts.

Money market funds (MMF)

In essence, MMF are a type of mutual fund (a fund that pools assets from many investors). The securities traded in these markets can include U.S. treasuries, commercial paper, and repurchase agreements.

Specifics aside, these securities can be classified as low-risk (unlikely to lose investors’ money) and have a very short maturity, meaning they reach peak value in a brief period of time (usually 90 days or less).

This aspect above makes money markets appealing for short term cash necessities.

MMF are used largely by institutions, businesses, and state and local governments to store excess cash in between periods or payment. By doing this, they offer themselves liquidity (the ability to withdrawal quick cash when needed) and a modest rate of interest.

There are three main components which make MMFs a valuable tool for investors:

  • HIGHLY LIQUID – Securities traded in money markets have a high liquidity, meaning they can be easily bought and traded without affecting the price and are easy to withdrawal for quick cash
  • SHORT MATURITY – Financial instruments also have a short maturity rate, meaning they reach their highest value in a relatively short amount of time (often one year or less)
  • LOW RISK – Money markets are considered a safe alternative to stock markets since the financial instruments used carry very little risk

So, how does any of this apply to you? If you’re not yet sound asleep, first of all: congratulations, you’re on your way to becoming a finance expert. Second of all: you’ll be glad to know that money markets might potentially help put a little more cash into your pocket:

Money market accounts (MMA)

MMA are not unlike checking accounts, and can be easily created through one’s bank. They work similarly to a checking or savings account in that individuals use them to store money.

Though similar to both saving and checking accounts, MMA offer a few distinct advantages:

  • HIGHER INTEREST RATES – MMA usually offer investors between a 1 to 1.5 percent interest rate of return as opposed the typical .5 percent interest of a savings account
  • LIQUIDITY – MMA offer investors the ability to transfer funds between the MMA and checking accounts (usually online) and are typically more liquid than a counterpart like a certificate of deposit (CD).

MMA may have their advantages, but they aren’t for everyone. Some specific aspects of MMA to take into account before depositing include:

  • LIMITED CHECKING – a depositor is allowed up to six transfers or withdrawals from their account per month, meaning that those looking to cash checks on a consistent basis shouldn’t deposit their money in an MMA.
  • HIGHER INITIAL BALANCE – though MMA offer a higher interest rate, they also require a higher initial principal (larger sum of money in initial deposit), which can range from $1,000 to $25,000 depending on the account

The takeaway

To deposit or not to deposit? That is your question. Money market accounts aren’t for everyone, but there are some investors who might benefit greatly.

To help decide, below are traits that an ideal MMA candidate might have

  • HIGH BALANCES – an ideal MMA candidate would be able to maintain a higher balance on a monthly basis (usually about $5,000 or more is recommended)
  • ONLY NEEDS OCCASIONAL ACCESS – since MMA offer limited access to their balance, an ideal candidate wouldn’t be required to make frequent transfers or withdrawals
  • LOOKING FOR LOW RISK – MMA are low-risk, which means they are also low reward. Those looking for substantial gains in their deposits might not want to consider other options
We measure success by the understanding we deliver. If you could express it as a percentage, how much fresh understanding did we provide?
James Pero