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Zero interest on I bond confuses saver

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Dear Dr. Don,
I’ve been buying Series I bonds since 1999. I noticed in May that the interest rate went to zero. Does this mean there is no interest paid on bonds bought now until the rate changes again? I’ve always been confused on how interest is calculated on Series I bonds.
— Dennis Double-Ought

Dear Dennis,
The Series I savings bond yield is based on two components. The first is a fixed rate established when you bought the bond. It never changes over the life of the bond. The fixed rate is currently 0.1 percent for bonds purchased between May 1, 2009, and Oct. 31, 2009. The fixed rates from earlier purchases have ranged from zero to 3.6 percent.

The second rate is based on the inflation rate, as measured by the Consumer Price Index, or CPI. That rate changes every six months and is based on the inflation rate as measured over the past six months of CPI data. The most current inflation rate, announced May 1, was a negative 2.78 percent for the six-month period from September 2008 to March 2009. (March data isn’t reported until April, making it the latest data available for the Treasury to use when announcing May 1.)

The TreasuryDirect Web page “I Savings Bonds Rates & Terms” provides an example on how to calculate the annualized interest rate for currently issued Series I savings bonds:

Here’s how the composite rate for I bonds issued May 2009 to October 2009 was set:
  • Fixed rate = 0.10%
  • Semiannual inflation rate = -2.78%
  • Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
  • Composite rate = [0.0010 + (2 x -0.0278) + (0.0010 x -0.0278)]
  • Composite rate = [0.0010 + -0.0556 + -0.0000278]
  • Composite rate = [-0.0546278]
  • Composite rate = -0.0546
  • Composite rate = -5.46%
  • Composite rate = 0.00% (Composite rates are never less than zero)

The negative inflation rate is high enough to wipe out the fixed-rate component for any previously issued Series I savings bond. That means that during the first new interest period following the May 1 announcement, your savings bond will earn no interest for the following six months.

It’s the interest payment cycles that typically confuse people. The Treasury announces new rates twice a year — on May 1 and Nov. 1. If you bought the bond last August, for example, you’ll earn zero percent interest from August 2009 to February 2010.

If you have a Series I savings bond that is less than 5 years old and you’d like to redeem the bond, this deflationary period can give you the opportunity to effectively do so without paying an interest penalty. The early redemption penalty is the last three months interest. If the bond is past three months into the period of earning no interest, the Treasury gets three months of zero percent interest when you redeem the bond.

Read more Dr. Don columns for additional personal finance advice.