Updated on 06.13.11

How the Shifting Economy Changes (and Doesn’t Change) Personal Finance Advice

Trent Hamm

When I first started writing The Simple Dollar, it was quite easy to find savings accounts that offered interest rates as high as 5%. Even more amazing, banks offered certificates of deposit (CDs) that had rates that approached (or sometimes crossed) 6%.

In that environment, there were a lot of pieces of personal finance advice that made sense that might not make sense now.

I’ll give you a clear example: CD ladders. I wrote about the idea of CD ladders almost four years ago, but the concept is simple to explain. Let’s say that a bank is selling 3-month CDs at 5%.

On January 1, you buy a CD.
On February 1, you buy a second CD.
On March 1, you buy a third CD.
On April 1, the CD you bought in January matures. You use the proceeds from that to buy another CD.
… and so on.

After the first three months, you can just use the proceeds to buy another CD. This was a great thing to do with a large emergency fund by parking a month of living expenses in each CD because if you have a CD maturing each month that holds a month’s worth of living expenses, you can live on a chain of such CDs if you need to.

Here’s the thing, though. Compared to an ordinary savings account, a CD has some benefits (a higher interest rate) and some drawbacks (you essentially can’t touch it until it matures, meaning your money is locked away). In order for the benefits to outweigh the drawbacks, the interest rate on a CD has to be notably higher than the interest rate on a savings account.

In 2007, you could often find interest rates that were 1% or even 1.5% higher on a CD than on a savings account. That sort of gap made the difference worthwhile and made buying CDs make sense.

Flash forward to today. Rarely can you find a CD that’s more than 0.25% higher than what you can get in a savings account. That gap makes CDs a lot less appealing because of the flexibility you have to give up to get them. Thus, the changing economy has changed some sensible planning for cash savings.

There are many examples of these types of changes, such as credit card arbitrage, individual company investing, and so on. The more specific the investment or financial choice you’re discussing, the more likely it is that the advice you’re given will change with time and the economic tides.

If that’s the case, what good is such advice? Advice that describes very specific investments are good for people who want specific directions to follow, but it’s important to note that such advice becomes dated very quickly.

A much better approach is to understand the principles behind what you’re doing so that you don’t need the specific advice. How much is the drawback on that CD really worth to you? I price it at around 1% – the lack of liquidity really is a drawback. So, if a CD beats my savings rate by 1% or more, I’ll put some of my savings into a CD. Otherwise, I’ll let it be. This rule works when the economy is doing well and when the economy is doing poorly.

The best personal finance advice works no matter what the economy is doing. Spend less than you earn. Invest in a diversity of things, including yourself. Avoid debt unless you have a guaranteed return that greatly exceeds the interest you’ll pay on that debt. Save for purchases you know are coming in the future so that you can avoid debt.

It is those timeless principes, when well understood, that will guide you no matter what the economy is doing. Specific advice is usually just a clarification of those principles for the current moment, and when those moments pass, that specific advice becomes far less useful. It is far better to understand the true ideas behind them.

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  1. krantcents says:

    It is funny how we make it so complicated! The simple truth is spend less than you earn! It is a little like diets. There are thousands of diet books which really say the same thing. Eat less and burn more calories.

  2. Steve says:

    The other problem is that some mainstream advice seems to change with the zeitgeist. When the housing market is going up, you get articles about how to buy a house, find creative financing, why buying is always a good deal, etc. When it’s going down, you get articles about selling in a down market, why it’s ok to rent, etc. Most of this advice is NOT timeless.

  3. J.D. says:

    Where oh where do I invest my emergency fund?

  4. Holly says:

    It’s still a good idea in my mind to ‘park’ your EF in a place that’s less easy to get to, i.e. a cd, esp. if you feel ‘rich’ if your accounts are flush with cash. You can still get to the money if it’s really necessary…you will just forfeit a small bit of interest to do so. With the interest rates at such low rates it’s hardly a penalty.

  5. Steve says:

    My emergency fund is a combination of savings, laddered CD’s and some funds that pay monthly dividends. The philosophy is to add money automatically to the savings. When this gets to a certain dollar amount, I roll some of it into a CD that fits my ladder. We have approximately enough in CD’s to pay our living expenses over 6 to 9 months. Finally, and with some risk, I have taken some of the funds and have purchased some monthly funds that generate income between 4 and 10% monthly. Yes I have increased risk, but I also have a monthly return for my emergency fund that is 5%.

  6. Sandra says:

    I recently redeemed a CD that was going to renew at 0.4%. And yes, that number is correct.

  7. Tom says:

    I like that the very first comment on your link back to 2007 says “I’d like your opinion on this in Sept 2010.” Close enough.
    The 1% rule seems very similar to the rule people use when they’re deciding to refinance a mortgage. How long of a time horizon do you look at Trent? up to 18 months?

  8. Daniel says:

    I used to ladder my emergency fund in CD’s but have not for quite awhile due to the low rates. However I have a large emergency fund of 6 months and have recently been thinking about putting some of that money (less than half) into Series I Treasury Bonds that are currently at 4.6%. Any thoughts on these? I know you can’t cash them in for at least a year but after that the money is good to cash in if you ever need it for a 3 month interest penalty. These are paying considerably more than my online savings account at 1%. I was thinking about laddering into the Series I bonds with half my emergency fund or less. Any thoughts?

  9. Tamara says:

    I saw today that my SmartyPig interest rate dropped from 1.35% to 1.1%, I just started my e-fund back in April, I don’t have a lot in there & haven’t gotten my first interest disbursement yet but it’s still kinda disheartening.

  10. jackowick says:

    Thank you for writing this. Talking finance with friends, family, coworkers has been like throwing feathers in a pillow fight for the past five years. Everyone insists they are right because

    A) you are rejecting old and proven advice or..
    B) you are rejecting new trends and insights based on the current markets.

    Personally, I love laddering CDs and I still have some I roll over, but it’s not as high of a priority right now. If I have an immediate need for emergency cash, I’m okay with keeping more cash in traditional accounts than a CD, because of current rates. But part of a CD that helps with money discipline is keeping the money out of sight, out of mind. If I drop my ATM check card and someone gets my PIN, there are more barriers to get my money in the CD (yes I get my money back from fraud charges, but the point is reducing collateral damage and clean up mess. Having my mortgage payment “temporarily” missing from my checking is a big deal, but I could still move a CD to cover a due payment during the turnaround time etc etc. Please don’t pick on the details, you either get the main point or you don’t…)

    And going back to this article’s theme, why do people regard it as a “mistake” or “wrong” when you reevaluate and change strategy?

  11. Josh says:

    This is why savings dollars are always best inside a life insurance policy, you will gain tax free growth around 4 percent and have complete liquidity and access to your money.

  12. People don’t understand that they can’t keep doing things in the same old way they used to. It is hard to live off of CD interest when CD’s drop to 0.5% (our bank’s 12 month CD rate as of today). They need to research other options to guarantee their monthly income, but they are afraid to…they just keep rolling that 12 month CD, hoping rates will rise–just like they’ve done for the past three years. Meanwhile, they could have been earning 4% or more in an alternative investment. They are losing money by waiting.

  13. ben says:

    I started a CD ladder a couple years ago, when rates were on their way down, but I’m still sticking with it. The ebb and flow of interest rates doesn’t matter much to me, it’s more important for me to have the ladder process in place.

    I also don’t feel that I sacrifice much liquidity. At ING the early withdrawal penalty is three months interest, which is a small price to pay in the event that I NEED that money. Such a situation would be large enough where I wouldn’t care about the small loss of interest on that particular CD.

    By getting the ladder setup and the process autmated, when the interest rates on CDs go back up, I will be all set to automatically get those rewards without having to scramble and setup a ladder.

  14. kristine says:

    please elaborate- which funds?

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