Why You Usually Get Your Best
Savings Deals from Money Funds

When the Federal Reserve began raising interest rates last summer, bank money market accounts were paying almost 1% more than money market funds. Now, after the Fed's actions have had time to work their way through the system, money funds have pulled ahead by about 0.30% and you can expect the gap to widen further in the coming months. Here's why.

When you open a savings account at your bank (that is, lend them your money), your bank turns around and lends your money to others at a higher rate than it's paying to you. Obviously, the less it pays you on your savings, the more profit it makes. The problem with this arrangement is that you and your bank are financial adversaries.

Fortunately, there are other borrowers, the "big time" players, who would like you to lend to them and will usually pay you more interest than your bank will. These organizations include the federal government, big corporations, and even other banks. Here's where a special type of mutual fund comes in, one that specializes strictly in the short-term lending of money in the financial markets. Hence, its name: money market fund.

Your money market fund is on your side; it will try to get you the best rates it can, while still not taking undue risks. You give the fund your money; the fund gives you one of its shares for every $1 you put in. It takes your money and lends it out to the big time players. Most of the time, it gets a rate of interest 1% to 1½% higher than your bank will pay you over the same time period. However, from mid-2001 through mid-2004, the Fed had pushed rates so very low that the funds lost their competitive advantage and the banks' usually inferior rates looked better by comparison. Thankfully for savers, that trend has now reversed.

Investors in a money market mutual fund receive all of the fund's investment income after very small operational expenses are paid. The value of your money market fund shares doesn't fluctuate; they're kept at a constant $1—the same amount you paid for them. As the fund earns interest from its investments, it "pays" you your portion by crediting you with more shares. You earn interest, that is, receive more shares, every single day. The longer you leave your money in, the more shares you'll have. In this way, you are assured of getting all of your money back, whenever you want it, plus all the interest you've earned in the meantime.

There are three different kinds of money market funds: (1) The most common are the ones that lend money to businesses and banks. These corporate-oriented money market funds invest primarily in bank certificates of deposit and commercial paper. They pay the highest yield to investors and, not surprisingly, are the most popular. (2) For people who want added safety, there are money market funds that lend money only to the federal government and its agencies. Given the excellent track record of the corporate kind, it's debatable whether the added caution of sticking strictly with Uncle Sam's securities is worth the slight reduction in yield. (3) For people who are in high tax brackets, there are money market funds that invest only in tax-free municipal bonds that are very close to maturity. The income is free from federal income taxes. The current leaders in all three categories are listed in our Current Best Rates tables .

• Current Best Rates tables 
• Boost Your Returns Via an SMI-Recommended Money Fund
• Paying Yourself First
• SMI Savings Accounts page

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