How Money Market Account Interest Works
Money market funds are a popular alternative to bank savings accounts and cash holdings. Although their high level of liquidity and interest payment features make money market funds appear nearly identical to bank savings accounts to many investors, the way in which money market funds operate and the associated investment risks are inherently different.
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Function
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Money market funds are mutual fund investments in high-quality, high-liquidity short-term securities. Money market funds may invest in certificates of deposit, United States Treasury bills, commercial paper, repurchase agreements, short-term bonds or in other money markets funds. By law, money market funds may not invest greater than 5 percent of assets with any single issuer except for government securities or repurchase agreements and must maintain a weighted average to maturity of 60 days or less.
Features
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Money market funds operate under the concept of net asset value, or NAV. NAV is the per-share value of the money market fund's assets less liabilities. Investors in money market funds typically receive one share for every $1.00 invested into the fund. Money market fund managers strive to maintain the NAV of the fund at $1.00 per share.
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Interest
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Money market funds declare dividends daily. Dividends are typically paid for amounts in excess of the $1.00 per share NAV and are equal to the fund's net investment returns less the expenses of the fund. Expenses of the fund include transaction costs, management fees and administrative costs of the fund. The dividends of the fund are credited to the individual investor and reinvested back into the fund. Most commonly, these dividends are referred to as the interest earned on the fund.
Risks
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Although most people consider money market funds a higher-yielding alternative to bank savings accounts, they are often riskier and lack the FDIC insurance benefits of bank savings accounts. Some money market funds do offer third-party insurance coverage for investors. Additionally, in the event of insolvency of the fund operator, it is possible that some investors will see delays in the ability to withdrawal their investment. Such an event would be very rare.
Warning
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Money market fund managers make a significant effort to maintain the $1.00 NAV. During times of poor credit and illiquid markets, however, this may be difficult. Failing to maintain the $1.00 NAV is known in the industry as "breaking the buck.". Breaking the buck involves returning investors less than 100 percent of the funds they invested -- in effect a negative rate of interest. This is very rare, but did occur to some funds during the 2008 financial markets credit crisis.
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References
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