by Archie M. Richards, Jr., CFP^®
May 5, 2003

Your money market fund is paying only about 0.8 percent - yikes! How can you increase the income on your cash?

The best way is to buy a broad selection of index funds of domestic and foreign stocks. These won't increase your current income, but they will certainly increase your future income and your future wealth. Those are the main things.

But let's assume you're unwilling to do that, with at least part of your money. This column explains some of the alternatives.

Money Market Funds: Money market funds lend money to corporations for periods of about 30 days. Some of the loans come due every business day. Any cash not needed to cover investor withdrawals is lent out again.

The interest paid on each loan remains fixed for the loan's duration. But the loans are constantly being replaced with new ones. Over time, the interest rate of the fund as a whole gradually changes. The prices of money market funds, however, do not change. With rare exception, the prices remain at $1.00 a share. Because the loans are so short, the interest rates are low.

The prices of all loans move opposite to the changes in interest rates. If interest rates rise, prices go down. If interest rates fall, they go up. The prices always mature at par; a thousand-dollar loan matures at $1,000.

Long-Term Loans: The longer a loan's maturity, the greater the price fluctuation. Assume that you buy a $10,000 bond due in 30 years. It pays $500 a year, or 5 percent. For the entire 30 years, the interest payments remain constant.

Five years later, the bond, originally a 30-year bond, is due in only 25 years. The interest rates on new 25-year bonds are 7 percent - 40 percent higher than the 5 percent you've been receiving. If you sell your bond then, you'll receive only $7,669.

You bought the bond for $10,000 and sold for only $7,669. You lost $2,331 - almost a quarter of your capital. Long-term bonds are volatile in price.

(If the buyer of your bond holds to maturity, the combination of the $500-a-year interest plus the gain of $2,331 he receives when the bond matures gives him a yield-to-maturity of 7 percent.)

Short-Term Loans: Short-term loans are not volatile in price. Assume you buy a 3-year note for $10,000. It pays $200 a year, for an interest of 2 percent.

A year later, interest rates on two-year notes are 2.8 percent - 40 percent higher than the 2 percent you've been receiving. If you sell then, the price will be $9,846. That's a loss of only $154, or 1.5 percent.

Short term loans do fluctuate in price, but not by much.

Corporate Loans: The interest paid on corporate bonds slightly exceeds that of Treasuries of the same maturity. I recommend Vanguard's Short-Term Corporate Fund. A loan to a single corporation is riskier than a loan to the federal government. But this Vanguard fund acquires the bonds of over 400 companies. Moreover, it selects bonds that are highly rated by third party rating services. An investment in such a fund is safe.

The income yield of this fund is an impressive 3.3 percent, and the maturities of the bonds in the portfolio average only 2.5 years. As they mature, the fund buys new ones, all of short duration. Over time, the rate of interest paid by the fund changes. The price does too, but not by much.

I don't know whether interest rates will move up or down during the next few years. But five or ten years out, I expect rates to be lower than they are now. Bonds by then will have risen in price. You'll have a profit. Every little bit helps.

Do you fit the following profile?

• You're a married woman;

• You retained your maiden name;

• You're self employed;

• You file income taxes jointly with your husband.

If so, your Social Security account has a reasonably good chance of being wrong. Check it out. Order a current Social Security statement via www.ssa.gov/mystatement or by calling 800-772-1213.