(SmartAsset) - I want to understand how I bonds work. When the interest rate changes, does that new rate apply to previous bonds – but at a different rate? - Joseph
I bonds have been popular lately and for good reason. The interest payments that you receive from an I bond adjust for inflation.
That capability is especially important as consumers experience high inflation. The consumer price index (CPI) rose 8.2% in September over the previous year. That has many investors eyeing any investment that can keep up with inflation and ease the sting of rising prices.
I bonds’ annualized inflation rate of over 8% for 2022 has proven valuable compared to the fixed payments you typically receive from most other types of bonds. Instead of losing value in real terms, I bond payments have kept up with increases in the CPI.
The precise way this adjustment applies, however, seems to be a constant source of confusion. I’ll provide some background information on I bonds here and hopefully clear it up for you. (If you have questions specific to your financial situation, consider working with a financial advisor.)
What Is an I bond?
An I bond is a debt instrument issued by the U.S. Treasury. That inflation-adjusted payment is the defining feature that separates it from other types of bonds. It’s what makes them so popular.
I Bond Interest Rate
Now for the interest. There are two components of the total interest rate (composite rate) on I bonds.
Fixed rate. A fixed interest rate is set at the time the bond is issued and won’t change for the life of the bond, which is potentially up to 30 years. On May 1 and Nov. 1 each year, the Treasury announces the fixed rate that will apply to any bond issued for the next six months. Since May 1, 2020, the fixed rate on all I bonds has been 0%.
Inflation rate. The other component is the variable interest rate that adjusts with inflation. This is what drives changes in the amount of interest you receive each month. As with the fixed rate, the Treasury announces the new variable rate on May 1 and Nov. 1 every year. The difference, though, is that the change is applied to existing bonds, not just newly issued ones.
The inflation rate was 9.62% for bonds purchased through October. As of Nov. 1 the rate is 6.89%.
How Do I Bond Interest Rates Work?
The Treasury Direct website offers a good and digestible explanation of the mechanics, but I have a succinct answer here that helps you understand when and how the new rate applies to you.
When you buy an I bond, you will receive the composite rate that is in effect at the time you buy the bond for six months. After, you receive the next announced composite rate for the next six months. This process continues until you cash in your bond or it matures at 30 years.
That’s it. Another way to think of it is that when you buy an I bond, you know what your interest rate will be for six months. New rates come in six-month intervals. If that statement alone makes sense to you, then you’ve got it. I’ll demonstrate with an example too using previous rates.
Example of I Bond Interest Rates
Consider this excerpt from a Treasury Department chart showing historical I bond composite rates.
Period when you bought your I bond: May 2020 – October 2020
Composite rate: 9.62%
Period when you bought your I bond: November 2019 – April 2020
Composite rate: 9.83%
Period when you bought your I bond: May 2019 – October 2019
Composite rate: 10.14%
For example, let’s say you bought an I bond at any point from May 2019 to October 2019. You would have received an annualized rate of 10.14% for six months regardless of which month in that range the purchase had occurred.
Let’s assume you experience that rate from August 2019 to January 2020. When the new rate was announced on Nov. 1, 2019, it didn’t immediately apply to you because it had not yet been six months from the time you purchased your bond.
Instead, that became your rate in February 2020 when your initial six-month period ended. You would have received that new rate (9.83%) for the six months from February to July 2020, at which point the next rate (9.62%) would have kicked in.
Other Important Facts to Know About I Bonds
Before purchasing an I bond, there are a few other features you need to understand. They are:
Although I bonds make monthly interest payments to the investors who hold them, these payments don’t come directly to you like the coupon payment on a corporate bond. In other words, you don’t receive cash flow from your I bond while you hold it. Instead, the payments are added to the principal value and you get the total when you redeem the bond.
You are required to hold them for at least one year after purchase. If you redeem them within five years of the time you purchase them, you’ll forfeit three months’ worth of interest.
Notice I use the word “redeem.” That’s because there is no secondary market for I bonds, which means you can’t trade them. You must purchase I bonds directly from the Treasury, then redeem them with the Treasury when they mature or you decide you no longer want to hold them.
I don’t bring these up to suggest that I bonds are bad. It’s just that they are somewhat unique and could catch you off-guard if you didn’t think to check before buying one. For example, someone buying an I bond hoping to use the interest payments for rent may be in for a surprise.
Another unique element is that the Treasury limits the amount you can purchase within a year. Each year, an individual can purchase:
$10,000 of electronic I bonds through the Treasury Direct website
$5,000 of paper I bonds with your tax refund
What to Do Next
The new rate of 6.89%, which took effect Nov. 1, 2022, is still a good rate, but it is lower than 9.62%. Remember, you get six months of the rate that is in effect when you complete your purchase.
Brandon Renfro, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
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By Brandon Renfro, CFP®