The term money market can be confusing because it is used to describe two entirely separate types of investments. A money market account is a cross between a checking and savings account. In exchange for a higher interest rate than a standard account, a depositor agrees to write a limited number of checks against the account each month. The principal is guaranteed and the account is FDIC insured. Like checking and savings accounts, money market accounts are demand accounts that offer stability and liquidity.

Money market funds, however, are mutual funds. The principal is not guaranteed and is not insured by the FDIC. Money market fund managers purchase investments in order to keep the net-asset value (NAV) of the fund at $1.00 without ever losing money. Most money market funds are required by the Security and Exchange Commission to invest at least 95% of the assets under management in U.S. Treasuries and short-term commercial paper that carry the highest credit rating from at least two major credit rating agencies. Money market funds therefore do present at least some risk, but less risk than other types of mutual funds. Because of the different types of money market funds available, they can and do have a place in every investor’s portfolio. Those who want to reduce taxes on investment income should especially consider money market funds.

Types of Money Market Mutual Funds

There are three primary types of money market mutual funds: U.S. Treasury-only funds, tax-exempt funds, and general funds. All of these funds invest only in cash and cash-equivalent investments such as bankers’ acceptances (a short-term credit investment that is created by a company and guaranteed by a bank), certificates of deposit, commercial paper (unsecured, short-term debt that is issued by a corporation), repurchase agreements (short-term borrowing by dealers of government securities), and U.S. Treasuries. While U.S. Treasuries enjoy the full faith and credit of the United States federal government, commercial paper is solely dependent upon the credit rating of the company that issues it. A company with a high credit rating usually has no problem selling paper. A company that has a lower credit rating, and therefore a higher risk of default, is not usually allowed to sell paper into this market. Depending on the type of fund, it will invest in one, two, or a combination of these instruments. Note that just like other mutual funds, money market funds maintain a certain position in cash in order to meet daily redemption requirements.

As the name implies, U.S. Treasury-only funds invest solely in U.S Treasuries. These are the safest of all funds because the risk of default is so low. But these funds almost always pay a lower yield than the other types of funds. This kind of fund is best for an investor with a very low tolerance for risk or who has a very short-term savings goal. For example, an elderly investor who would not be able to tolerate a loss of investment might choose a Treasury-only money market fund to hold a portion of his or her portfolio.

Tax-exempt money market funds are exempt from federal income tax, and in some cases, from state and local taxes as well. These types of funds hold short-term municipal securities as the majority of assets. While tax-exempt funds are also relatively safe, they pay a lower yield than U.S. Treasury-only funds to account for the tax exemption. A tax-exempt money market fund is perfect for an investor with a high net worth, one who is in a high marginal tax-bracket, or for one who resides in a high-tax state.

General funds hold a variety of assets, from U.S. Treasuries to corporate bonds. While general money market funds are also deemed safe, there is a greater risk with them than there is with U.S. Treasury-only and tax-exempt funds. The inclusion of short-term corporate paper generally increases yield but also increasesrisk. Even corporations on sound financial footing with excellent credit ratings face the risk of default, however small. Given a smaller amount of inherent risk, general money market funds are still well-suited for individuals who need a higher rate of return than is paid on a standard savings or checking account.

Money Market Funds for Small Business

It’s important to note that small businesses, too, can benefit from money market funds. Small companies that may be sitting on a safety net of cash should consider general money market funds in conjunction with regular savings accounts. The higher rate of return, safety, and liquidity offer multiple advantages over other types of accounts.

Money Market Funds as Sweep Accounts

Those with investment accounts (not individual retirement accounts) at brokerage firms are probably most familiar with money market funds as sweep accounts. Brokerage houses usually open a money market fund with each new account automatically. This account is then used for deposits, dividend payments that aren’t reinvested, and to hold cash when securities, mutual funds, or ETFs are sold.

When to Invest in a Money Market Mutual Fund

In general, a money market fund is often considered a cash parking lot. Most investors will want to keep a certain amount of money in the fund, but only enough for upcoming anticipated expenses or purchases. Depending on the economic environment, money market funds may pay only slightly above the rate of inflation. And that’s not nearly enough for anyone to build a nest egg that will last through retirement.

Before investing in a money market mutual fund, consider your investment objectives. Like any investment, even those that are relatively safe, the best ones provide you with diversification and a way to meet your goals without taking on excessive risk. Finally, consider the fees associated with the fund. Like all mutual fund companies, the company that manages your money market fund will charge annual expenses and fees in order to maintain the account, paperwork, and all regulatory considerations. Make sure the expenses are comparable to those charged by other fund companies and don’t exceed the costs of similar-yield savings vehicles like money market accounts, CDs, and US bonds.

While we’ve covered the basics of mutual fund investing here, there is much more to maximizing the success of your fund investment strategy. To make sure you’re on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now .