How Do Savings Bonds Work?
Savings bonds are a low-risk investment that pays interest. They are issued by the U.S. government. Here’s everything you need to know about U.S. savings bonds.
May 23, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
Investors have a wide range of choices available to them.
On the higher risk, higher reward side of the equation, there are assets like stocks, real estate and cryptocurrency.
On the lower-risk, lower rewards side, there are certificates of deposit (CDs) cash, and savings bonds.
Savings bonds can present an attractive option for a stable, low-risk investment. But how do savings bonds work exactly?
This comprehensive guide will discuss U.S. savings bonds, including the Series I and Series EE bonds.
What are savings bonds?
Savings bonds are a financial product sold by the U.S. federal government. Individuals can buy these bonds from the government and the government will promise to pay them back — with interest.
Savings bonds are generally owned for up to 30 years. However, they can be redeemed after as little as one year. The holder of the bond has the option to redeem (cash out) the bond at any point after the first year.
When an investor redeems their bond, they will receive the entire principal amount back, plus any interest that has been accrued.
You can think of buying a savings bond like making a loan to the government. You can purchase a $1,000 savings bond and that $1,000 will go to the government. When you eventually redeem the bond, you’ll get your $1,000 back, along with interest.
Note: “Savings bonds” may also refer to bonds in general. Most bonds work similarly but bonds can be issued by governments, municipalities and companies alike. Savingsbonds generally refer to U.S. government savings bonds, such as the Series I and Series EE bonds.
How do savings bonds work?
How do U.S. savings bonds work, exactly?
You can purchase savings bonds from TreasuryDirect. This is the U.S. Government’s official portal for buying and redeeming treasury bills and bonds. You cannot buy savings bonds anywhere else — they are not sold through traditional stockbrokers or trading apps.
There are two main types of savings bonds: Series I and Series EE. These will be discussed in more detail below.
Both types of U.S. savings bonds share these features:
Can be purchased online through the TreasuryDirect website
Minimum purchase amount of $25
Maximum purchase amount of $10,000 per year (per person)
Must be owned for a minimum of one year before redeeming
Earn interest for 30 years (or until redeemed)
Are subject to federal income tax on interest payments but are exempt from most state and local taxes
Have an early redemption penalty — if redeemed before five years, the investor will forfeit the last three months of interest (if you redeem after 30 months, you’ll only receive 27 months' worth of interest).
Interest compounds semi-annually (every 6 months)
Both Series EE and Series I bonds share all the properties listed above. The main difference is in how they earn interest. How do savings bonds work in terms of the interest they pay? Keep reading for more info.
Types of U.S. savings bonds
There are two main types of U.S. savings bonds available for purchase: Series EE bonds and Series I bonds.
Series EE Bonds
Series EE Bonds earn a fixed rate of interest (currently quite low) but are guaranteed to double in value if kept for 20 years. For this reason, they make the most sense for long-term investors looking to keep the bonds for 20 years.
The rate on EE bonds is usually quite low. But if you keep them for 20 years, they will end up doubling. This works out to an average rate of around 3.5% — but only if you redeem them after 20 years.
Series I Bonds
Series I Bonds pay a rate of interest that is based on the current rate of inflation. The interest rate changes every six months.
I-Bonds actually have a two-tiered interest rate structure:
Fixed-rate: This is a set rate that is fixed for the life of the bond.
Inflation rate: This is a variable rate that is changed every 6 months. It is based on the current rate of inflation in the US, as measured by the consumer price index (CPI).
For example, let’s say that the fixed rate is currently 0.25% and the current inflation rate is 3.4%.
In this case, buying an I-bond today would result in a total interest rate of 3.65% (0.25% fixed plus 3.4% inflation).
However, remember that I-bond interest rates change every six months, even for bonds that you already own. The fixed-rate (0.25% in this example) stays the same but the inflation rate changes every six months (in April and November).
If inflation were to rise to 3.8% in this case, the bond would start earning 4.05% (3.8% + 0.25%) at the next rate change. If inflation were to fall to 2.9%, the bond would start earning 3.15% (2.9% + 0.25%).
Advantages of savings bonds
Low-risk: Savings bonds are guaranteed by the full faith of the U.S. government. It’s impossible to lose money on a savings bond unless the government literally collapses and is unable to pay its debts.
Exempt from state/local taxes: Interest earnings from U.S. savings bonds are exempt from state and local income taxes (but are still subject to federal income tax).
Do not fluctuate with the stock market: Unlike most other assets (even other types of bonds), the value of savings bonds does not fluctuate with the stock market. This makes them useful for diversification.
Disadvantages of savings bonds
Low rate of return: Savings bonds generally have a lower rate of return than higher-risk assets, like stocks.
Requires a TreasuryDirect account: You can’t buy a savings bond through an existing investing account, or in a retirement account. You must buy from TreasuryDirect.
Adjustable rate: Series I bonds have an adjustable rate that changes every 6 months — even for existing bonds. There’s no way to know for sure what the rate will be in the future.
1 year minimum holding period: You cannot redeem a newly purchased bond until you’ve owned it for at least one year.
Early withdrawal penalty: If you redeem a bond within five years of purchase, you will forfeit the last three months of interest. For example, a bond held for three years (36 months) would only pay you 33 months of interest, due to the early withdrawal penalty.
U.S. savings bonds present a safe, low-risk investment. They typically earn more interest than something like a savings account, but tend to earn lower returns than investments like stocks.
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