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Alternative to Bank CDs

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United States I Bonds can be a good alternative to bank certificates of deposit. Treasurydirect.gov has all the details about I Bonds. Some of the key points include:
  • Can't be redeemed within 12 months of issue date
  • Lose 3 months interest if redeemed within 5 years
  • Interest is composed of fixed and inflation-based rate
  • Fixed rate remains for life of bond
  • Inflation-based rate changes every 6 months after issue date
  • New rates announced every six months on November and May 1st
  • Federal tax can be deferred on interest until bond is redeemed
  • Interest is exempt from state and local tax
  • Some or all interest is tax exempt when used for educational expenses
  • $60K maximum of I Bond purchases per year ($30K online and $30K paper) Update: New limit of $10K starts in 2008. See post.

Currently, I Bonds have a fixed rate of 1.2% and an inflation-based rate of 3.60% for a composite rate of 4.80%. This was set on May 1st of this year. On November 1st new rates will be announced. The fixed rate has generally tracked short term interest rates. It increased from 1.0% to 1.2% last May. The inflation-based rate is based on the government's CPI-U numbers. For November 1st, the inflation-based rate will depend on the CPI-U numbers from last September and March. You can see how this is computed from this MyMoneyBlog post.

The government reported September's CPI-U numbers on Friday. So based on this, the inflation-based component for the new I Bond rate on November 1st is now unofficially known. And it's a whopping 5.69%. The jump in gas prices in September really had an impact here.

So if the fixed rate stays the same at 1.2%, the new composite rate will be 6.92% (see this MyMoneyBlog post for details).

But this doesn't equal a bank CD of 6.92%. The interest rate will change every six months based on inflation. Also, there's the 3-month interest penalty until 5 years.

With some math, I've been able compute what I call CD-equivalent interest rates for terms of 11, 12, 13 and 14 months. Why these terms? By purchasing an I Bond at the end of the month and redeeming an I Bond at the first of the month, you can effectively get a month of free interest. This also shortens the non-redemption period from 12 to 11 months. For example, if you purchase on I Bond on October 31st, you can redeem that I Bond the following year on October 1st. Note, it's best not to wait too late in the month or the actual issue date may get delayed into the next month. So the effective terms will likely be a few days longer than I listed.

Another reason why I picked these terms is that if you go longer than these, you have to factor in the interest rates that will come out next May and beyond. A 14-month term is the longest that we can go without any uncertainty in the rates. Also, this can only be done in the last half of October and April. That is when the CPI-U numbers are known that will be used for the next inflation-based rate.

Here's an example of how the CD-equivalent 14-month rate is computed:

If you purchase an I Bond at the end of this month, you'll get 6 months of the current component rate of 4.80% (from November through April 2006). Then you'll get the new rate from May 2006 through October 2006. If the bond is redeemed early in the month of January 2007, you'll forfeit the interest from November through January. The rate from May 2006 through October 2006 will be 6.92%. So here's how the effective annual interest is computed:

The total return for 14 months can be approximated by:
4.80 * 6/12 + 6.92 * 6/12 + 0 * 3/12 = 5.86%

The effective annual interest rate can be approximated by:
5.86 * 12/14 = 5.02%

So if you buy an I Bond on October 31, 2005 and redeem it on January 1, 2007, that would be approximately equivalent to opening a 14-month CD on October 31, 2005 with an interest rate of 5.02%. Factor in the state tax exemption and it becomes an even better deal. Also, by redeeming on January 2007, you defer federal taxes until 2008.

Below is a table of the CD-equivalent rates for 11 through 14 months. The best deal is with 14 months.

I Bond CD-Equivalent Rates

Assumed I Bond purchased on Oct 31, 2005

Terms Annual Interest Rate
11 mo ending Oct 1, 06 4.51%
12 mo ending Nov 1, 06 4.71%
13 mo ending Dec 1, 06 4.87%
14 mo ending Jan 1, 07 5.02%

One more note! It's best to purchase I Bonds with a few days before the end of the month to ensure the issue date will be the current month.

As can be seen, these rates exceed the best national CD rates for similar terms. The nice thing about I Bonds is that if you don't need the money and the inflation rates continue to be high, you can continue to own the I Bond. Federal tax can then be deferred some more.

It'll be interesting to see the news when the rates are announced in November. Unless the fixed rate makes a big decline (probably unlikely) the rate will be around 7%. This will look very attractive when most bank CDs are still under 5% and when the stock market has been so bearish.
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