I Bonds vs. Certificate of Deposits
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There are several investors who like to make short-term investments since they want to enjoy high liquidity at all times. However, they are also not willing to take high risk and if you resonate with them, you might want to consider I bonds and certificates of deposits to park your funds in. They are both highly safe and secure investment options but differ in a lot of ways. In this guide, we compare I bonds and certificate of deposits to help you choose the best option.
In this article
What are I bonds?
I bonds, also known as , are a type of U.S. government savings bond issued by the Department of the Treasury. These bonds are designed to offer a safe and low-risk investment option while protecting against inflation.
Features of I bonds
Inflation protection
One of the primary benefits of I bonds is that they offer protection against inflation. The interest rate on I bonds is composed of two components: a fixed rate and an inflation rate. The fixed rate remains the same for the life of the bond, while the inflation rate adjusts every six months based on changes in the Consumer Price Index for All Urban Consumers (CPI-U). This means that the overall interest rate on I bonds can keep pace with inflation.
Purchase and denominations
I bonds are available for purchase online through the TreasuryDirect website or by using your tax refund. They are sold in denominations as low as $25, with a maximum purchase limit of $10,000 per person per calendar year. In addition, you can purchase an additional $5,000 in paper I bonds with your tax refund.
Tax benefits
Interest earned on I bonds is exempt from state and local income taxes. While it is subject to federal income tax, you can defer paying federal taxes on the interest until you redeem the bonds.
Liquidity
I bonds have a minimum holding period of one year. However, if you redeem them within the first five years, you will forfeit the most recent three months' interest. After five years, you can redeem them at any time without penalty.
Maturity and interest
I bonds have a 30-year maturity period, during which they continue to earn interest. However, they stop earning interest after 30 years, so it's generally recommended to hold them for at least that long to maximize their benefits.
Pros and cons
Pros
- Safety. I bonds are issued and backed by the U.S. Department of the Treasury, making them one of the safest investments available.
- Inflation protection. One of the primary benefits of I Bonds is their inflation protection. The interest rate on I bonds is composed of both a fixed rate and an inflation rate. This ensures that the bond's overall return keeps pace with changes in the cost of living.
- Tax advantages. Interest earned on I bonds is exempt from state and local income taxes. While it is subject to federal income tax, you can defer paying federal taxes on the interest until you redeem the bonds.
- Low minimum investment. I bonds can be purchased with as little as $25, making them accessible to a wide range of investors.
- Flexible terms. I bonds have a 30-year maturity period, during which they continue to earn interest. However, you can redeem them after just one year with a minimal penalty, making them relatively liquid compared to some other long-term investments.
- No transaction fees. There are no fees or commissions associated with buying or holding I bonds, which means that your entire investment goes to work for you.
Cons
- Interest rate risk. The fixed rate on I bonds remains constant for the life of the bond, so if you purchase them during a period of low-interest rates, you may not earn as much interest over time.
- Liquidity constraints. While I bonds can be redeemed after one year, there is a penalty for redeeming them within the first five years. This penalty involves forfeiting the most recent three months' interest.
- Long-term commitment. I bonds have a 30-year maturity, and their maximum interest rate adjustment occurs after 20 years. This means that you are making a long-term commitment when you invest in them, and they may not be the best choice for short-term savings goals.
- Limited investment amount. There is an annual purchase limit for I bonds, which can restrict the amount of money you can invest in them.
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What are certificates of deposit?
A certificate of deposit (CD) is a financial product offered by banks and credit unions that allows individuals to deposit a specific amount of money for a fixed period of time at a specified interest rate. CDs are a type of time deposit, meaning that you agree to keep your money in the account for a set period, known as the maturity period, in exchange for a higher interest rate compared to regular savings accounts or checking accounts.
Features of CDs
Fixed terms
CDs have fixed terms, which can range from a few months to several years. Common CD terms include 6 months, 1 year, 2 years, and 5 years, although other terms are also available.
Fixed interest rates
When you open a CD, you receive a fixed interest rate that remains constant throughout the CD's term. This means you know exactly how much interest you will earn over the life of the CD.
FDIC or NCUA Insurance
CDs offered by banks are typically insured by the Federal Deposit Insurance Corporation (FDIC), while those offered by credit unions are insured by the National Credit Union Administration (NCUA). This insurance provides protection for your deposit, up to specified limits, in case the financial institution fails.
Interest payment options
Depending on the terms of the CD, interest can be paid out in different ways. Some CDs compound interest and add it to the principal, while others may allow you to receive regular interest payments (e.g., monthly, quarterly, or annually).
Automatic renewal
If you don't take any action at the end of the CD's term, many financial institutions automatically renew the CD for another term. It's essential to check the renewal terms and rates to ensure they meet your financial goals.
Competitive rates
CD interest rates can vary depending on market conditions and the financial institution. Generally, longer-term CDs offer higher interest rates than shorter-term ones.
Related: Best CD Bank Rates
Pros and cons
Pros
- Safety. CDs are considered one of the safest investments available. When you purchase a CD from an FDIC-insured bank or an NCUA-insured credit union, your deposit is typically insured up to specified limits.
- Predictable returns. CDs offer fixed interest rates for a specific term, providing predictability in terms of returns. You know exactly how much interest you will earn over the life of the CD.
- Liquidity options. While CDs are time deposits with fixed terms, many institutions offer a range of term lengths, including shorter ones like 6 months or 1 year.
- Variety of terms. You can choose from various CD terms, ranging from a few months to several years, allowing you to tailor your investment to your financial goals and timeline.
- No market risk. Unlike stocks and some other investments, CDs are not subject to market fluctuations. Your interest rate is locked in, so you don't have to worry about the ups and downs of the stock market affecting your investment.
Cons
- Low returns. CDs tend to offer lower interest rates compared to other investment options, such as stocks, bonds, or even some savings accounts.
- Penalties for early withdrawal. CDs come with penalties for withdrawing funds before the maturity date. These penalties can result in the loss of a portion of the interest earned or even a portion of the principal. This lack of liquidity can be a drawback for some investors.
- Tax implications. Interest earned on CDs is typically subject to federal income tax, and you'll need to report it when you file your tax return. Depending on your tax bracket, this can reduce your overall returns.
- Inflation risk. If the interest rate on your CD is lower than the rate of inflation, your purchasing power may decrease over time, and you may not keep up with rising prices.
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Key differences
I bonds and CDs are both investment options, but they have several key differences.
Issuing entity
I bonds are issued by the U.S. Department of the Treasury and are backed by the federal government. They are considered one of the safest investments available because they are backed by the full faith and credit of the U.S. government. CDs are issued by banks and credit unions. They are also relatively safe, particularly if they are offered by FDIC-insured banks or NCUA-insured credit unions, as they are insured up to specified limits.
Interest rate
The interest rate on I bonds consists of two components: a fixed rate that remains constant for the life of the bond and an inflation rate that adjusts every six months based on changes in the Consumer Price Index (CPI). CDs offer a fixed interest rate that remains constant throughout the CD's term. The rate is determined by the issuing bank or credit union at the time of purchase.
Inflation protection
I bonds are designed to provide protection against inflation. The inflation component of the interest rate ensures that the bond's overall return keeps pace with changes in the cost of living. CDs do not typically offer inflation protection. The interest rate on a CD is fixed and does not adjust for changes in inflation.
Holding period
While I bonds have a one-year minimum holding period, they can be redeemed after one year without penalty. However, if you redeem them within the first five years, you will forfeit the most recent three months' interest. CDs generally have more rigid terms and penalties for early withdrawal. If you withdraw funds from a CD before its maturity date, you may incur penalties, which can result in the loss of interest.
Interest payment
Interest on I bonds can be deferred until redemption. You can choose to receive the interest when you redeem the bond. CDs offer various interest payment options, including monthly, quarterly, semi-annually, or annually, depending on the terms set by the issuing institution.
Minimum investment
I bonds can be purchased with as little as $25, making them accessible to a wide range of investors. The minimum investment amount for CDs can vary significantly between banks and credit unions, but it's typically higher than the minimum for I bonds.
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FAQs
Which is riskier? I bonds or CDs?
Both I bonds and CDs are low risk investment products and are considered safe haven investments. However, I bonds are safer than CDs since they are backed by the U.S. Government.
What are the different types of bonds?
There are five types of bonds you can invest in. These are corporate, municipal, Treasury, savings and agency.
Can you lose money on the CDs?
You will not lose money on a CD but if you withdraw before the maturity date, you could end up paying a penalty and it will reduce your overall earnings.
The bottom line
In summary, I bonds and CDs are both low-risk investment options, but they serve different purposes. I bonds are designed to protect against inflation and offer a more flexible interest rate structure, while CDs offer a fixed interest rate for a set term and are typically more accessible in terms of minimum investment amounts. Your choice between the two will depend on your financial goals and preferences.
I bonds can be a useful addition to an investment portfolio for those looking for a low-risk option that provides inflation protection. Keep in mind that they are not designed for quick access to funds, as there is a one-year minimum holding period and a penalty for redeeming them within the first five years. On the other hand, Certificates of Deposit can be a useful tool for savers and investors who want to earn a fixed and predictable rate of return on their money without taking on the risk associated with more volatile investments like stocks or bonds. They are especially popular for short- to medium-term savings goals or for individuals looking to preserve their capital while earning some interest.
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