What a money market mutual fund holds

A money market mutual fund is a fund that invests in short-term debt instruments — mostly government bonds, corporate IOUs that mature within months, and bank certificates of deposit. The fund buys these instruments, collects the interest payments, and passes that income to you as a shareholder. Because the underlying investments are short-term and low-risk, money market funds aim to keep their share price stable at $1 per share while paying you a small yield.

The fund manager decides which specific short-term securities to buy. A fund focused on U.S. Treasury instruments will hold only government debt. A fund focused on corporate paper will hold short-term loans from companies. Some funds hold a mix. The manager's job is to find the highest yield available while keeping the fund's value steady and ensuring you can withdraw your money quickly.

Money market funds are different from money market accounts at a bank. A bank account is a deposit product insured by the FDIC up to $250,000. A money market fund is a mutual fund — it owns securities, not a bank deposit, and carries market risk, though that risk is small.

Key Takeaways

  • Money market mutual funds invest in short-term debt that matures in less than one year, such as Treasury bills, commercial paper, and certificates of deposit.
  • The fund aims to keep its share price at $1 while paying you interest income, making it a low-volatility investment compared to stock or bond funds.
  • You can buy money market fund shares through a brokerage account, and most funds let you withdraw money within one or two business days.
  • Money market funds are not FDIC-insured like bank deposits, so there is a small risk that the fund's value could fall below $1 per share.
  • The yield on money market funds changes with interest rates — when the Federal Reserve raises rates, yields rise; when rates fall, yields fall.

How the yield works and what you earn

The yield on a money market fund is the annual return you receive from the interest paid by the securities the fund holds. If a fund holds Treasury bills paying 5 percent and commercial paper paying 4.5 percent, the fund's yield will be somewhere between those rates, depending on how much of each it owns. The fund subtracts its operating expenses before paying you, so your actual yield is slightly lower than the weighted average of the underlying securities.

Money market funds distribute income in different ways. Some pay dividends monthly or quarterly. Others reinvest the income automatically, which means your share count grows but you do not receive a cash payment. Check the fund's prospectus to see its distribution schedule. The yield changes constantly because the fund is always selling maturing securities and buying new ones at current market rates.

Because money market funds hold very short-term debt, their yields move quickly when interest rates change. When the Federal Reserve raises its benchmark rate, new securities pay higher interest, and the fund's yield rises within weeks. When rates fall, the fund's yield falls just as fast. This is why money market funds are sometimes used as a temporary place to hold cash while waiting for better opportunities elsewhere.

The difference between taxable and tax-exempt money market funds

A taxable money market fund invests in Treasury bills, corporate commercial paper, and bank CDs. The interest income you receive is subject to federal income tax and, in most cases, state and local income tax as well. These funds typically offer higher yields than tax-exempt funds because the income is taxable.

A tax-exempt money market fund (also called a municipal money market fund) invests in short-term debt issued by states, cities, and other local governments. The interest income is exempt from federal income tax and often exempt from state and local tax if you live in the state that issued the bonds. Tax-exempt funds pay lower yields than taxable funds because the tax break makes them more valuable to investors in higher tax brackets.

Whether a tax-exempt fund makes sense depends on your tax bracket and where you live. A high-income earner in a high-tax state may come out ahead with a tax-exempt fund even though its stated yield is lower. A lower-income earner or someone in a low-tax state will usually earn more from a taxable fund. You can compare the after-tax yield of both types to decide which fits your situation.

How to buy money market fund shares

You buy money market mutual fund shares through a brokerage account — either a regular taxable account or a retirement account like an IRA or 401(k). Open an account with a broker such as Fidelity, Vanguard, Charles Schwab, or another firm, then search for the specific money market fund you want. You can buy shares directly if the fund is offered by that broker, or you may pay a small transaction fee if it is not.

Some brokers offer their own money market funds with no transaction fee. Others charge a small fee to buy funds from other companies. A few brokers waive fees for funds in their own family. Check the fund's prospectus and the broker's fee schedule before you buy.

Once you own shares, you can sell them and withdraw the cash. Most money market funds process redemptions within one or two business days, though some may take longer during periods of market stress. Some brokers let you write checks directly against your money market fund balance, which makes it function almost like a checking account.

Why money market funds carry a small amount of risk

Money market funds are designed to be very safe, but they are not risk-free. The main risk is that the fund's share price could fall below $1 — an event called "breaking the buck." This happens if the securities the fund holds lose value faster than the fund's income can offset. In practice, this is rare. It happened during the 2008 financial crisis when one major fund held debt from Lehman Brothers, which collapsed.

A second risk is interest rate risk. If you own a money market fund and interest rates rise sharply, the fund's yield will eventually rise too, but the securities already in the fund will pay the old, lower rate. You will not see the benefit of higher rates until those securities mature and the fund buys new ones. This is a timing issue, not a loss of principal, but it means your returns lag behind rising rates for a few weeks.

A third risk is credit risk — the risk that a company or bank that issued the commercial paper or CD the fund holds will default. Money market funds manage this by holding only the highest-quality short-term debt and spreading investments across many issuers. The risk is small but real.

Money market funds versus other short-term savings options

A high-yield savings account at a bank pays interest on your deposit and is FDIC-insured up to $250,000. The yield is usually close to what a money market fund pays, but your money is fully protected. The trade-off is that you cannot buy individual securities — you are relying on the bank's decisions. Withdrawals are usually when ready or next-day.

A Treasury bill (T-bill) is a short-term government bond you can buy directly from the U.S. Treasury through TreasuryDirect. T-bills mature in 4, 8, 13, 26, or 52 weeks. You know exactly what you will earn and when. The downside is that you must hold until maturity or sell on the secondary market, and you can only buy in $100 increments. A money market fund gives you more flexibility and lets you withdraw at any time.

A certificate of deposit (CD) is a bank product where you deposit money for a fixed period — usually 3 months to 5 years — and earn a may provide rate. CDs are FDIC-insured and pay a fixed return, but you cannot withdraw early without a penalty. Money market funds let you access your money anytime without penalty.

A money market account at a bank is a hybrid between a checking account and a savings account. It pays interest, is FDIC-insured, and lets you write checks or make withdrawals, but the bank can limit how many withdrawals you make per month. Money market funds have no withdrawal limits.

How expenses affect your return

Every mutual fund charges an annual expense ratio — a percentage of your investment that covers the fund manager's salary, administrative costs, and other operating expenses. Money market funds typically charge between 0.05 percent and 0.50 percent per year, though some charge more and some charge less.

The difference matters over time. If two money market funds both hold securities yielding 5 percent, but one charges 0.10 percent and the other charges 0.40 percent, you will earn 4.90 percent from the first and 4.60 percent from the second. Over ten years on a $10,000 investment, that 0.30 percent difference adds up to roughly $300 in lost earnings.

Check the fund's prospectus for its expense ratio before you buy. Many brokers publish this information on the fund's detail page. Lower-cost index funds that track the money market are often cheaper than actively managed funds.

Frequently Asked Questions

Can I lose money in a money market mutual fund?

Losing principal is unlikely but possible. The fund's share price is designed to stay at $1, and it usually does. However, if the securities the fund holds decline in value faster than the fund's income can offset, the share price could fall below $1. This is called breaking the buck and is rare. During normal market conditions, your main risk is that your yield will be lower than you expected if interest rates fall.

What happens to my money market fund when interest rates change?

When the Federal Reserve raises interest rates, new securities the fund buys will pay higher rates, so the fund's yield will rise within a few weeks. When rates fall, the fund's yield falls. Your principal does not change, but the income you earn changes with market rates. This is why money market funds are sensitive to Federal Reserve decisions.

Can I hold a money market fund in a retirement account?

Yes. You can hold money market funds in an IRA, 401(k), or other retirement account. Many people use them as a temporary holding place for cash they plan to invest elsewhere, or as a conservative core holding for people nearing retirement. The tax treatment depends on the account type — in a traditional IRA, distributions are taxed as ordinary income; in a Roth IRA, may have access to distributions are tax-free.

Is a money market fund the same as a money market account?

No. A money market account is a bank deposit product insured by the FDIC. A money market fund is a mutual fund that owns securities and is not FDIC-insured. Money market accounts often have withdrawal limits and lower yields. Money market funds let you withdraw anytime and usually pay yields closer to current market rates.

How do I choose between different money market funds?

Compare the expense ratio, the current yield, and the types of securities the fund holds. A lower expense ratio means more of the yield goes to you. A fund holding Treasury securities is safer than one holding corporate paper. Check whether the fund distributes income monthly or reinvests it. Read the prospectus to understand the fund manager's strategy and any restrictions on withdrawals.