Question: My house is almost paid off. I now want to build a larger emergency fund. Putting money into a savings account or CDs will not keep up with inflation. I have been purchasing an I-bond every month for almost 5 years. The interest is frequently over 3% and has been as high as 6%. Are I-bonds a safe place to park emergency funds? Pamela, Port Orchard, WA
Answer: Yes, U.S. I-bonds are a safe place for emergency money, with an important caveat. Savings bonds redeemed before the 5 year mark forfeit the 3 most recent months' interest (that's the only penalty). After 5 years that there is no penalty at redemption.
With the emergency savings people might need to tap, say, when the boiler goes next year or when you face a major car repair bill in two year they'll usually do better putting that money into an online savings account. However, once they've created a large enough financial buffer I think adding I-bonds into the mix is a savvy move.
However, in your particular case since you've been buying I-bonds for almost 5 years you can always sell the older ones without a penalty. The older I-bonds are a key part of your savings.
I like savings bonds because there's no credit risk with them. Your money compounds tax-deferred until they're cashed in. There are no commission costs to buy and sell savings bonds. You don't pay state and local government taxes when you redeem the bonds.
I-bonds are specifically designed to be a hedge against inflation. Every dollar you invest will be worth a dollar plus some interest in the future when the bonds are cashed in. The return on an I-bond is made up of two parts: a fixed-rate of interest and a rate that adjusts to changes in the consumer price index. Taken altogether I-bonds issued between May and October of 2011 will earn at an annual rate of 4.60%.
The big advantage of the I-bond for the long-term investor is that inflation won't erode the value of your dollars if inflation takes off sometime over the next several years as many economists fear.