Are I Bonds A Good Investment Option Now?

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Is now a good time to invest in I Bonds? With the recent cut in interest rates by the Federal Reserve bank in the last month or so, many online banks, such as ING Direct , have lowered their interest rates, most under 3.5%. While this is better than 0.2% in a regular local bank savings account, people looking for the most out of their money are always on the lookout for better returns. Well, the I bond currently pays 4.28%. I Bonds, a type of savings bond issued by the U.S. Treasury, pay a composite or total rate, which is a combination of an inflation component and a fixed component. Below is a table of I Bond rates for the past 2+ years. With I bond, the fixed rate remains the same for the life of the bond, while the inflation rate “resets” every six months, for a new composite or total rate. Underneath the table is an explanation of how the composite rate is calculated.

DATE            INFLATION                 FIXED             COMPOSITE
RATES*                  RATE               (TOTAL)RATE
1-Nov-07        1.53%     1-Nov-07       1.20%              4.27836%
1-May-07       1.21%      1-May-07      1.30%             3.73573%
1-Nov-06       1.55%      1-Nov-06       1.40%             4.52170%
1-May-06      0.50%      1-May-06      1.40%             2.40700%
1-Nov-05       2.85%      1-Nov-05       1.00%            6.72850%
1-May-05      1.79%       1-May-05      1.20%            4.80148%

Here’s how the composite rate for I bonds issued Nov. 2007 – Apr. 2008 was set:

Fixed rate = 1.20%
Semiannual inflation rate = 1.53%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.0120 + (2 x 0.0153) + (0.0120 x 0.0153)]
Composite rate = [0.0120 + 0.0306 + 0.0001836]
Composite rate = [0.0427836]
Composite rate = 0.0428
Composite rate = 4.28%

Historical Averages: 2 Year average 4.41%, 10 Year average 4.65%

I bond Pros and Cons:

Pros:

I bonds are currently returning 4.28%, a pretty good rate considering ING, for example, is returning 3.40%
The interest on I bonds can be taxed deferred, meaning they do not have to be reported on a yearly basis (as savings account interest would be)
The interest from I bonds are tax free if used for education.

Cons:

I bonds cannot be cashed in for 1 year. So if you have any idea that you may need the money in that time frame, this is not an option for you.
If you cash I bonds in before 5 years, there is a penalty of 3 months interest. (i.e., you lose 3 months worth of interest.)
I bond rates change twice a year, the next rate change will take place May 1st (The rates are usually released a few weeks earlier) So that 4.28% could (and may) go down, leaving you locked in at a lower rate for at least six months. Although the historical averarage over the last 10 years is over 4.5%.

If you have money you will not need for at least a year, I bonds may be an option to look in to. If you cash them in before 5 years you will lose 3 months interest. If you will not need the money for 5 plus years, they could end up being pretty good. Using them as part of education savings make them quite attractive-especially with the low risk.
Since you can purchase any amount starting with $25.00, adding them to your investment portfolio in small increments may be something to consider. By starting with small increments, and adding them on a monthy basis, you can create a “ladder” of I bonds, and after 60 months, each one will become “cashable” with full interest.