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A Beginner’s Guide to Money Market Mutual Funds

If you are searching for a mutual fund where you could park your excess money for a short-term and earn risk-free returns, Money Market Funds (MMFs) are highly recommended. Read this post to know the basics of MMFs.

An Overview of Money Market Fund

It is often challenging for investors to find a mutual fund if they have a shorter investment horizon of less than a year. The choices get fewer if the investor aims to generate risk-free returns from this short-term investment.

If you are looking for the same and have run out of the options, it is time for you to know about Money Market Funds (MMFs). So, what is a Money Market Fund? How does it work? Take a look-

What Are Money Market Mutual Funds?

In simple words, MMFs are mutual funds that invest your money in high-quality, fixed-income, short-term debt instruments. For instance, the investment could be in –

  • CDs (Certificate of Deposits),

  • CPs (Commercial Papers),

  • Repurchase Agreements (Repos),

  • T-Bills (Treasury Bills), etc.

All of these are highly liquid debt instruments that earn a fixed interest income. This makes MMFs one of the safest types of mutual funds. Moreover, these securities generally have a maturity of 1-year. So, if you want to invest for a shorter duration of even a few months, MMFs can still be a great risk-free investment option.

Benefits of Investing in Money Market Funds

Now that you have a brief idea about what is a money fund, let us have a look at some of their top benefits

  • Risk-Averse Investing

    As discussed above, MMFs only invest in high-quality debt instruments that offer fixed interest income and have shorter maturities. So, if you want to earn decent returns over a short duration while keeping risks to a minimum, these funds can be an excellent option.

  • Higher Returns Than a Savings Bank Account

    A savings bank account is where a lot of people park their excess money. The balance maintained in the account then earns interest. But MMFs generally offer higher returns than standard savings bank accounts. Just like the bank account, you are free to withdraw your money anytime you like.

  • Ideal for Short-Term Financial Goals

    Short-term financial goals like child’s school or college fees, loan EMI, etc. can be effectively achieved with the help of MMFs. You get to generate higher returns as compared to most options generally preferred for such short-term goals.

Are Money Market Funds Completely Risk-Free?

Along with understanding what is a Money Market Mutual Fund, one should also know the risks of investing in MMFs. While these funds are generally known to be risk-free, they do carry some amount of risk.

For instance, MMFs have interest rate risks. If the interest rates start falling, the underlying assets get more expensive and vice versa. Also, the returns are not guaranteed. You can never know the exact returns your investment will generate over a fixed period. But the fund managers keep this risk to a minimum by only investing in high-quality debt instruments.

Taxation of Money Market Mutual Funds

As MMFs are a type of debt fund, the capital gains are taxed accordingly. For investments held for less than 36 months, the returns are added to the taxable income of the investor and taxed as per his/her income tax slab.

Investments held for over 36 months attract LTCG (Long-Term Capital Gains) tax at the rate of 20% with indexation benefit. Indexation helps you increase the purchase cost of the MMF to make up for inflation during the holding period. This helps in reducing the taxable gains.

Who Should Invest in Money Market Funds?

Money Market Mutual Funds are ideal for risk-averse investors wanting to earn higher returns over a tenure of 3 months to 1 year. If you want to invest for durations of more than one year, there are better options such as Balanced Funds or Dynamic Bond Funds that can deliver higher returns.

But make sure that you select a top MMF offered by a reputed fund house. Also, check the portfolio of the scheme to make sure that it has only invested in high-quality debt instruments. The investments made by MMFs generally have Credit Quality. It is better only to select funds with a Credit Quality of ‘AA’ and above.