Personal Finance

Return to Article

Savings Bond Rates Set to Slump Soon

Terry Savage

Certain savings bond rates are about to drop sharply -- just as rates on every other government security are rising!

If you buy the government's Series I bond before Monday, you'll earn 6.73% interest for the next six months. But if you buy the inflation-adjusted bond after Monday, it's likely that you'll earn only about 2% for the coming six months! (The final determination on the new Series I bond rate will be made by the Treasury department on Monday.)

If you'd like an explanation, I'll give it my best shot. But if you are looking to lock in high rates -- for a while, at least -- you should rush to your financial institution or go to TreasuryDirect.gov and place your order. (Individuals can purchase up to $30,000 of paper I-bonds, and an additional $30,000 of bonds electronically every year.)

And now back to that conundrum of falling savings bond rates in a period where rates ranging from fed funds to mortgages all seem to be on the rise. It's all about the way the rates on Series I savings bonds are calculated.

Savings bonds used to be the easiest way for people to put away small amounts of money and earn market rates of interest. But all that changed with Series I bonds, which were created in 1998. The rates change every six months, and the complicated interest rate formula means that current I-bond holders are earning rates that range from 6.73% to 9.40%, depending on when you bought the bonds.

That's because I-bond rates have two components. There's a fixed base rate for the life of the bond, determined at the time you buy the bond. When I-bonds were first issued in September 1998, the fixed base rate was 3.40%. And those bonds will continue to have that base rate for the 30-year life of the bond.

For the first few years, the base rate was changed every six months for new buyers, and until Nov. 1, 2001, it was at least 3%. Then it started dropping, and it is currently set at 1%.

The second part of the interest rate paid on I-bonds is based on a complicated formula. The government looks at its non-seasonally adjusted consumer price index twice during the year -- at the end of September, and again at the end of March.

It is the actual index number that is used to calculate the second portion of the I-bond interest payment. The Treasury compares the index change every six months. For example, in March 2005 the CPI stood at 193.3, but by last September (amid rising energy prices after the hurricanes), the index stood at 198.8, a pretty big jump. And that percentage jump in the index number (not in consumer prices, but in the index itself) is used to set the "interest rate factor" that is added to the promised I-bond base rate.

The calculation itself is more complicated than my high school calculus will allow me to explain! But you can find it on the Treasury Web site under the I-bonds section. Here's how it's explained:

Rate Calculation for I-Bonds Issued November 2005-April 2006

Fixed rate = 1.00%

Semiannual inflation rate = 2.85%

Composite rate = [Fixed rate + 2 x Semiannual inflation rate + (Fixed rate X Semiannual inflation rate)]

Composite rate = [0.0100 + 2 x 0.0285 + (0.0100 X 0.0285)]

Composite rate = [0.0100 + 0.057 + 0.000285]

Composite rate = [0.067285]

Composite rate = 0.0673

Composite rate = 6.73%

It was the huge jump in rate of change in the CPI in September that led to the new rate of 6.73% that was established Nov. 1.

But at the end of March, the unadjusted CPI stood at 199.8, up only 1 point from the previous 198.8. So doing the complicated math described above, it appears that the "semi-annual inflation factor" will be only 1% starting May 1.

Add that 1% to the base rate of 1%, and it looks like Series I bonds will pay only about 2% starting Monday and for the following six months!

Of course, if you have older I-bonds with a higher base rate, you'll get your new six-month rate by adding the 1% inflation factor to your base rate, plus a small "fudge factor" that recognizes you've held those older bonds. The actual rates will be posted at the Treasury Web site.

One more important note: If you buy I-bonds today at the current 6.73% rate, you'll keep earning that rate for the next six months. Then the rate on your bonds will drop to the expected 2% rate for the following six months. In fact, if current rising energy prices contribute to another big CPI jump when rates are reset on Nov. 1, you'll still be stuck earning that low 2% for the full six months.

You can't play the interest rate game with these bonds by selling when rates drop. You must hold I-bonds for at least one year before cashing them in. And if you redeem them before five years, you'll lose three months' interest!

Bottom line: Series I bonds are for long-term holders. Eventually, you'll get the benefit of all those six-month adjustments and you'll keep up with inflation. But starting May 1, the Treasury Department is going to have a lot of explaining to do. And that's The Savage Truth.