Although banks are convenient and safe, money market mutual funds and short-term bond funds are good alternatives to what the bank has to offer.
First let's examine money market mutual funds. These can be thought of as a variant of a bank checking account. The main advantage that money market mutual funds offer is higher yields.
Money market mutual funds are investment companies that buy short-term securities like 90-day US Treasury bills, large bank certificates of deposit, and short-term corporate debt called commercial paper. Money market mutual funds must invest in short-term securities so that the average maturity of the portfolio cannot exceed 90 days.
Because of these short-term investments, money market mutual funds are virtually immune from the interest rate risk that haunts mutual funds that invest in longer-term bonds.
By law money market mutual funds must invest at least 95 percent of their assets in either US government securities or other securities of the highest credit rating. Thus, money market mutual funds almost can be thought of as being safer than bank deposits.
Money market mutual funds do not enjoy the federal deposit insurance that banks have. However, this deposit insurance is not the cure-all that many think that it is.
For instance, if a bank folds, the deposits in the bank may be frozen for up to 30 days. As long as your deposit is under $100,000 you eventually should get all of your money back, but that could take months. Also, when a bank fails, you will get your original deposit back, but you may have to give up some of the interest you earned.
Without the deposit insurance, banks would be riskier places for deposits than money market mutual funds. Banks take most of their deposits and lend the money on either a long-term basis for things like commercial real estate, or lend the money to high risk borrowers like credit card users or auto purchasers.
Banks typically keep less than 20 percent of their deposits in their vaults to pay off depositors. If enough depositors want their money back, banks can't call their long-term loans back to fulfill the depositors demands.
When this happens, the bank must merge with someone or file for bankruptcy. Unfortunately, this isn't a rare occurrence. In the 1980s over 800 commercial banks and 600 savings and loans filed for bankruptcy.
Money market mutual funds are less likely to fail because they invest in high-grade, liquid, short-term debt. If lots of fund investors want their money back, the mutual fund simply sells the high-grade securities to the market, and uses the proceeds to pay off customer redemptions.
In fact, to date only one money market mutual fund has lost money for its investors, and that was a strange fund that was set up to invest for banks and was closed to the public at large.
Mutual funds also provide another safety valve that banks don't. The securities that the mutual fund purchases on behalf of investors are stored with a third-party custodian. This third party helps to prevent the mutual fund management from embezzling or otherwise misusing investor's funds.
Still, if you want ultimate safety, you should consider investing in a so-called US government money market fund. These funds typically place all their investments in securities that are backed by the "full faith and credit" of the US government.
Even here, you need to be a little careful. Beware of investing in so-called "government plus" money market funds. Such funds may invest in derivative securities which are backed by US government obligations. Such derivative securities may have little credit risk, but they may have a good deal of interest rate risk, even if they are short-term securities.
The American money markets are extremely efficient, and any fund that has a higher than average yield is either run frugally or is taking on extra risks. Be aware of what you're getting.
To avoid nasty surprises in this kind of mutual fund, or any mutual fund, make sure to read the fund's prospectus before investing.
Still, for the most part, money market mutual funds provide higher returns with little or no extra risk compared with bank accounts.
They can do this for two reasons. First, banks must pay insurance premiums to the FDIC to get the insurance coverage for their deposits. These premiums increased dramatically after the 1980s. Higher insurance premiums mean lower returns to you.
Second, mutual funds tend to have lower overhead than banks. Most large mutual funds like Vanguard do not have a nationwide chain of walk-in offices like banks do. With little invested in bricks and mortar, mutual fund companies can afford to pay higher interest rates and still show a profit.
Mutual funds also cut their costs by leaving small transactions to the banks. Typically, you must have $1,000, or even $3,000, to open a money market mutual fund. Money market funds offer lots of services like check writing, electronic transfers and automatic deposits and withdrawals, but checks usually have a minimum of $250.
Because of this, you might want to keep a couple thousand dollars in a local bank account for everyday cash management, and keep your three-to-six month emergency reserve in a higher paying money market mutual fund.
Money market mutual funds also offer one product that banks can't offer. If you have a high income, you might come out ahead by investing in a tax-exempt money market mutual fund. If you stay with a bank, all of your interest income is taxed.