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Money market funds - also known as money market mutual funds - are a saving and investing option offered by banks, brokerages and mutual fund companies. These funds are considered low-risk investments that can be suitable for short-term investment goals or building an emergency fund. Here's more information about how they work.

How money market funds work

Money market funds are regulated by the Securities and Exchange Commission, or the SEC, and are required to invest in short-term debt securities, such as certificates of deposit, U.S. Treasury bills and commercial paper. The funds have historically tried to maintain a share price of $1 and there have only been a few instances where a fund fell below that price, but there's no guarantee a fund will be able to do that.

Money market funds are required to purchase securities with maturities of 13 months or less, or in some cases 25 months if it is a government security. The weighted average maturity of a fund's portfolio must be 60 days or less. These requirements help to maintain the overall liquidity of money market funds and ensure that the portfolio won't be tied up in long-term investments.

Types of money market funds

There are a few different types of money market funds based on the security the fund invests in.

Prime funds invest in floating-rate debt and commercial paper issued by companies, U.S. government agencies and government-sponsored enterprises.Tax-exempt funds are typically made up of municipal bonds and are exempt from federal income taxes and in some cases state taxes.Government and treasury funds invest in cash and securities that are backed by the government, such as U.S. Treasury bills.

Reasons to invest in money market funds

Investors who are particularly risk-averse and focused on protecting their nest eggs may find that money market funds meet their investing needs. The funds can help you generate a return above what is offered by traditional bank savings accounts, but will have significantly less volatility than investments in the stock market, for example.

Money market funds allow you to write checks and make electronic transfers, but most accounts establish a minimum dollar amount for checks. Check with your institution to see if it imposes a fee after a certain number of withdrawals if your account balance drops below a certain level.

Some funds even come with tax benefits if they hold municipal securities that are exempt from federal and state taxes. If you're looking to generate a small return during retirement or are just saving for a rainy day, money market funds could be a great fit.

Are money market funds safe?

Money market funds are relatively safe in that they invest in low-risk securities with short-term maturities. That said, they are still an investment in securities which can lose value. Money market funds are usually considered to be safe investments, but it's important to remember that these investments are intended for the short term. With maturities of 13 months or less, the funds stay liquid and allow you better access to your money than longer-term investments. A crucial distinction investors must make is the difference between money market funds vs. money market accounts.

Money market accounts are interest-bearing savings products offered by banks and other financial institutions. These accounts are FDIC-insured up to $250,000 per depositor, per insured bank. Money market funds (or money market mutual funds) are not. It's important to know which option is best for you and your investment goals.

Drawbacks of investing in money market funds

The main negative of investing in money market funds is that you're not going to earn a large enough return to build wealth over time, or even outpace inflation. This fact makes these funds unsuitable for long-term savings goals such as retirement. Stock market investments likely make more sense for young people investing to meet goals that are still decades away. But for those already in retirement or if you're just saving, money market funds can be a good fit.

Another drawback is that money market funds are not FDIC-insured, even when you buy them at a bank. That means there is some risk, but historically it has been slight. You may find that the small amount of risk is worth it because money market funds traditionally pay a better interest rate than a traditional savings account.

Keep in mind that money market funds are different from money market accounts that banks offer as a savings tool. The accounts offered by banks are covered by FDIC insurance up to $250,000 per depositor, per insured bank, but the funds are not.

Finally, you'll want to keep an eye on the expense ratios for the funds you invest in. With the often low expected returns, fees can eat up a large percentage of your return if you're not careful. The average money market fund charged 0.13 percent in 2022, according to a report from the Investment Company Institute. That means you'll pay $13 for every $10,000 you have invested in a fund. You can find fee information in the fund's prospectus or through your online broker.

How to invest in money market funds

You can purchase money market funds in a few different ways. You can go directly to a fund provider such as Vanguard or BlackRock ( BLK ), purchase them through a bank, or through your online brokerage account. You'll likely have the most options through an online broker who will likely have funds available from a number of different providers.

If you plan to invest in the funds as part of a retirement strategy, consider purchasing through a traditional or Roth IRA to limit your taxes on gains and withdrawals.

Bottom line

Money market funds aren't going to make you rich, but they will provide a small return in a low-risk way, making them a good fit for retirees and those saving for short-term goals or building an emergency fund.