Money Markets:
Different Types of Money Markets
There are several different instruments
in the money market, offering different returns and different risks. The most common one
is Certificate of Deposit (CD).
Certificate of Deposit (CD):
CDs are time deposits offered by banks and insured by
the Federal Deposit Insurance Corporation (FDIC). You generally earn compound
interest at a fixed rate, which is determined by the current interest rate and
the CD's term, which can range from a week to several years. However, rates can
vary significantly from bank to bank, and some banks also offer or offer
adjustable rate CDs or hybrid CDs whose earnings are tied to a stock index such
as the Standard & Poor's 500-stock Index (S&P 500). You usually have to pay a
penalty if you withdraw funds before your CD matures, often equal to the
interest that has accrued up to the time you make the withdrawal.
CDs offer a slightly higher yield than T-Bills because of the slightly higher default
risk for a bank, but overall the likeliness of a large bank going broke is
pretty slim. Of course, the amount of interest you earn depends on a number of
factors such as the current interest rate environment, how much money you
invest, the length of time, and your specific bank.
A fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY)
and annual percentage rate
(APR). APY is the total amount of interest you earn in one year taking into
account compound interest. APR is simply the stated interest you earn in one
year, without taking into account compounding.
The difference results from when interest is paid. The more frequently interest
is calculated, the greater the yield will be. When an investment pays interest
annually, its rate and yield are the same. But when interest is paid more
frequently, the yield gets higher. For example, say you purchase a 1-year,
$1,000 CD that pays 5% semiannually. After 6 months, you'll receive interest
payment of $25 ($1,000 x 5 % x .5 years). Here's where the magic of compounding
starts. The $25 payment starts earning interest of its own, which over the next
6 months amounts to 62.5 cents ($25 x 5% x .5 years). As a result, the rate on
the CD is 5 percent, but its yield is 5.06. It may not sound like a lot, but
compounding adds up over time.
The main advantage of CDs is their safety and knowing the return you'll receive.
You'll earn more than in a savings account, and you won't be at the mercy of the
stock market. Plus, the FDIC guarantees your investment up to
$100,000.
There are two main disadvantages to CDs. The returns are paltry and your money
is tied up for the length of the CD. You can't get your money out without paying
a harsh penalty.
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What is
compound interest?
When the interest you
earn on an investment is added to form the new base on which
future interest accumulates, it is said to be compound interest.
Without compounding, you earn simple interest, and your investment
doesn't grow as quickly.
For example, if you earn 10% compounded interest on $100 every
year for five years, you'll have $110 after one year, $121 after
two years, $133.10 after three years, and $161.05 after five years
— for total growth of 61.1% on your investment. With simple
interest, you would have earned $10 a year for five years, for
$150, or 50% growth. The $11.05 difference is the effect of
compounding. Compound interest earnings are reported as annual
percentage yield (APY), though the compounding can be figured
annually, monthly, or daily.
Learn more about the power of compounding in our investing
session.. |
Next -->>
Other kinds of Money Market Instruments
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