Time to look at Savings Bonds (4.28%)

(interest rates will reset on May 1)

An inquisitive Rob Deals reader asked me about U.S. Savings Bonds, especially now that interest rates dropped again last week.  (Now WaMu pays just 3.3% and money markets are around 3%.)

There are 2 kinds of savings bonds, only one of which is currently worth buying:

• I Bonds (4.28%): This bond pays a fixed interest rate (1.2%, fixed for the life of the bond) plus inflation (currently ~3%).  Your interest rate will be adjusted 6 months for the prevailing inflation rate, which will in all likelihood get you more than the 3.3% banks are currently paying.  On May 1, the interest rates will be adjusted, and the fixed interest rate is likely to go down.  So you should buy these bonds before May 1.  One limitation is that you can only buy $10,000 of these bonds per SSN per year ($5,000 for paper bonds that you can buy from your local bank and $5,000 for electronic bonds via treasurydirect.gov).



• EE Bonds (3.00%): Fixed interest for the life of the bond.  No reason to buy these now.

As noted in an earlier post, the effective interest rate is much higher.  Because these are tax-advantaged investments, the effective rate on I Bonds is closer to 5% using this calculator (assuming a 28% tax bracket, California 9.3% tax rate, and 5-year holding period).

These rates don't take into account this tip: buy these bonds today (or at the end of any month), and you will get an extra month's worth of interest (interest is calculated monthly, and if you buy March 31, they give you interest for all of March).  And sell/redeem these bonds on the 1st of any month (e.g. April 1, 2009), and you get the full month's interest.  So effectively you get 2 months of free interest.  I get tremendous pleasure from stiffing the U.S. government, and hopefully you will too.

The only downside is liquidity: you cannot redeem these bonds for 12 months, and if you redeem before 60 months, you will forfeit the latest 3 months of interest (but if you use the strategy above, you can offset 2 of these 3 months).

Disclosure: No commissions earned.