Comparison of a Return of CD Vs. a Money Market
Cash management strategy combines safety of principal alongside the ability to collect interest payments. Certificates of deposit (CDs) and money market deposit accounts are cash management products that may be central to your financial plan. When making return comparisons between CDs and money market accounts, you must first differentiate between the basic structures of the two products. Cash management products expose you to distinct risks as a result of their low returns.
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FDIC Insurance
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As of 2010, the FDIC guarantees $250,000 worth of deposits per customer per bank. This FDIC insurance does extend over certificates of deposit and money market deposit accounts. As a large saver, you can divide one lump sum among multiple banks to insure the whole amount. For example, you could break up $600,000 into six $100,000 deposits at six banks to maximize your protection. Putting the entire $600,000 into one bank would leave $350,000 worth of deposits without insurance. Because of this FDIC protection, bank products are relatively low-risk and low-reward assets.
Features
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Certificates of deposit and money market deposit accounts are essentially loans you make to a banking institution. You collect interest payments in exchange for your loan principal. CDs generally feature maturity dates--the times at which your principal will be repaid. Throughout the CD term, you collect interest at a fixed rate. CD interest rates generally increase with the term length. For example, you should expect to earn higher interest rates on a five-year CD than you would for a one-year CD. Alternatively, money market deposit accounts do not carry a maturity date and pay interest with a variable-rate structure. At the same point in a time, a CD offers higher returns than a money market account. In the future, however, the money market rate may overtake the returns on that same CD, if interest rates rise.
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Federal Reserve
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The Federal Reserve Board manages the interest rate environment through monetary policy. In recession, the Fed mandates lower interest rates to reduce borrowing costs and encourage people to spend money and make investments. When rates fall, a CD you already hold offers relatively high returns. Meanwhile, money market deposit account interest payments would be on the decline. Alternatively, the Fed drives rates higher to protect a growing economy against inflation. At that point, you would benefit from a money market account, which has rates that would regularly increase. As interest rates move higher, CDs already in circulation would effectively lock savers into deposits that offer minimal interest payments.
Warning
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Because of their low returns, CDs and money market deposit accounts are both susceptible to inflation and opportunity cost risks. Inflation describes lost purchasing power on cash, while opportunity costs describe foregone profits from competing investments. For example, bank deposit returns are even less attractive when the stock market performs well. To manage financial risks and allow for growth, you can create a diversified portfolio of stocks, bonds and banking deposits.
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