Down on low CD rates? Try a savings bond
The Treasury Department has delivered a bolt of good news for savers.
Savings bond rates have been moved significantly higher for the next six months.
Rates are now high enough that -- hold on to your socks -- this has become an investment worth talking about.
What the Treasury Department calls Series I Bonds are the best. They're paying 4.60% right now, which is far more than even the best 5-year CD rates.
The rules are pretty simple.
The rate of return combines a semi-annual adjustment for inflation and a fixed rate set at the time of purchase that stays constant for the lifetime of the bond.
New rates are announced the first week of May and November every year based on the inflation adjustment.
To find the new rates you need to track the Consumer Price Index. This index rose between September 2010 and March 2011, marking a 2.3% semi-annual increase, which is doubled using the formula to determine what's called the composite rate.
This adjustment (along with the current fixed rate portion of 0% announced this week) marks the rate of return for the next six months for Series I holders.
Some purchasers of older Series I bonds will do even better.
In the past, the fixed rate portion has been as high as 3.60%. This means that some lucky holders are earning 8.20% on their investment until the rates reset again in November.
You can’t beat that rate of return for an investment that is backed by the U.S. government.
If you prefer a fixed rate, Series EE bonds also received a rate boost for savers.
The rate on the Series EE was moved up to 1.10% from 0.60% by the Treasury Department. That beats the best 6-month CD rates in our database.
It’s quite possible the Series EE could also outperform money market and savings accounts for the next six months to a year.
Series EE bonds have an interest rate that is fixed for 20 years. After 20 years, the Treasury Department can change the rate that applies for the final 10 years until maturity.
A feature of the Series EE that is often overlooked is the guarantee from the government that its value will double in 20 years. This work out to a 3.50% annualized rate if you manage to hold on to your bond that long.
Both the Series I and Series EE won't tie up your money for a long time, either.
You can cash them in after 12 months by paying a modest penalty of three months' interest. After five years, there's no redemption penalty.
This may surprise CD investors, who only buy savings bonds to save for college or as gifts for weddings, birthdays and bar mitzvahs.
Not to mention the people who consider buying one more of a patriotic gesture than a solid investment.
But CD rates have not kept up as inflation has picked up in the U.S.
Savers have been punished with low rates for reasons that stem back to the Federal Reserve and the credit crisis.
The Fed has kept interest rates artificially low despite an economy that is showing moderate growth and rising food and energy prices.
Their benchmark rate, the federal funds rate, has been targeted at 0% to 0.25% for overnight loans since 2008.
As a result, banks have an almost endless amount of free money and little incentive to offer high rates to attract deposits.
But banks aren’t even really biting on the free money.
Banks are still stinging from all the bad loans they made during the credit bubble.
Now, bankers are in a period of high caution. Loan volume is down as banks are more selective with the funds they lend out.
This means that until the Fed moves rates higher or bankers get over their fears, savers will see bank yields stuck in neutral.
The disparity between savings bond rates and CD rates won’t last forever. The Fed will eventually have to combat inflation and lift rates. Banks will also start lending again in earnest.
But for the immediate future, these should be tempting investments.
Think of it this way. You could buy a Series I or Series EE with the plan to hold it for one year and then pay the early redemption fee of three months interest when bank rates improve. You should come out ahead in this scenario.
Savings bonds also have several tax advantages:
- You don't have to pay tax on the interest you earn until the bonds are redeemed. With CDs, you're taxed on the interest in the year it's earned.
- The interest is exempt from state and local income taxes. That's a big plus for residents of states that levy a hefty tax on investment income, such as California and New York.
- The interest can even be exempt from federal income taxes if it's used to pay for eligible college expenses. (See IRS Publication 970, Tax Benefits For Education.)
Make your purchase at TreasuryDirect and have them issued electronically to your account.
You can buy a savings bond online for as little as $25.
Unfortunately, the government will only allow you to invest $5,000 a year in a single type of bond, under a single Social Security number.
The reduction from the previous $30,000 annual limit was made in 2008, supposedly to refocus the program on individuals with relatively small sums to invest.
But it's possible to buy $5,000 worth of I Bonds online, and another $5,000 worth of paper I Bonds, with a single Social Security number.
Or you can buy $5,000 worth of Series I online, and another $5,000 worth of Series EE online.
One final quirk:
If they're purchased electronically, they are issued at face value. So if you pay $1,000 for a bond, it is immediately worth that much.
Paper Series EE bonds are issued at half their face value. You will pay $500 for a $1,000 bond, but it will not be worth its face value until it matures.