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I-bonds and emergency savings

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.

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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.

About the author

Chris Farrell is the economics editor of Marketplace Money.
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