Traditionally, Ive held my emergency fund in the Vanguard Prime Money Market Mutual Fund (VMMXX ).  Several years ago, the Prime fund was riding high on the then-generous short-term interest rates, its yield topping 5% and staying there for a significant period of time.  At that point, Vanguard Prime was the highest-yielding high-quality cash-equivalent I could find, beating the yields on most of the newly-popular high-yield online savings accounts, such as ING Direct and WTDirect .

Dawn Of The Online Savings Account Era

As interest rates have dropped like a rock, so has the yield on my Vanguard Money Market Mutual Fund, which now yields a paltry 0.37%.  Top-tier online savings accounts, however, still routinely yield between 1.5% and 2%.

Why the discrepancy?  For commercial banks, the deposit base is everything.  How much a bank holds on deposit directly affects how much money it can lend out, which ultimately determines how much profit a bank generates.  In tough economic times, there often isnt a lot of spare savings to go around, so banks have to compete aggressively for whats left in the form of higher-than-average interest rates.  In the end, the bank with the most deposits generally wins.

High Yield Money Market Mutual Funds (in contrast to money market deposit accounts at the bank, which are a different animal), dont work quite the same way.  Money market funds are generally run by large institutions with hundreds of millions if not billions of dollars to invest.  When youre running that much money, small-time operations like an online savings account just dont cut it.  Money market funds demand a.) safety and b.) liquidity, which they attempt to get by spreading their money around between short-term Certificates of Deposit (just like the ones you can buy at your local bank), commercial paper (short-term loans between large corporations), short-term government securities (such as 90-day Treasury Bills) and other safe, secure short-term investments.  It is important to note, however, that Money Market Mutual Funds are not FDIC insured and are ever-so-slightly more risky than their savings account cousins.  To compensate, money market funds tend to offer slightly higher returns over the long term.

High Yield Money Market Vs High Yield Savings

High-yield savings accounts are FDIC insured and backed by the full faith and credit of the United States Government.  Money Market Mutual Funds are technically not FDIC insured; however, many of the underlying securities they invest in are actually backed by the U.S. Government.  For instance, almost 50% of Vanguard Primes portfolio is invested in ultra-safe treasury securities.  That said, several high yield money market mutual funds actually broke the buck and lost money in the recent financial crisis.  So far, all investors in failed funds have been compensated by the fund manager, but theres no guarantee that will always be the case.

Winner: High-yield savings

Currently, high-yield savings accounts yield more than the average high yield money market mutual fund, which is common during recessions when interest rates are very low.  When rates are high, however, money market mutual funds tend to have significantly higher yields than savings accounts.  Because of their slightly riskier nature, money market funds will tend to outperform savings accounts over the long run, if only slightly.

Winner: Money Market Funds

Both money market funds and online savings accounts allow for easy electronic transfers to and from your checking account.  Savings accounts, however, tend to have a monthly transaction limit while many (if not most) money market funds dont.  Money market funds also allow you to write checks directly from savings instead of first having to transfer the cash to your checking account.  Many savings accounts allow this too, but they are rarer.

Winner: Money Market Funds

Both money market funds and savings accounts offer similar types of online account management and electronic funds transfer.

Winner: Its a tie

Overall Winner

Which type of account you prefer ultimately boils down to your needs.  If you demand absolutely safety, an FDIC insured savings account is probably the way to go.  However, if youre willing to give up a very small amount of safety in exchange for slightly higher returns over the long run, a money market fund is probably your best bet.

Overall, both types of accounts are very safe and pay reasonable rates, on average.  At the end of the day, a few tenths of a percentage point on a few thousand dollars in your emergency fund isnt going to make much of a dollar-amount difference to your net worth.  The important thing is that youre saving for the future and not so much where you save it.