by Peter Sedesse

Created on: January 19, 2010   Last Updated: January 20, 2010

Savings Bonds are an investment vehicle issued by banks and credit unions.  In the simplest terms, a savings bond is a loan from you to the US government.  In exchange for the loan, the US government pays you interest on the money it borrowed from you.  The amount of interest paid to you by the government varies depending on the overall economic conditions in the world.  Savings bonds are a very safe investment tool as their is very little chance the federal government does not repay the loan, therefore the amount of return you can expect will be on the lower side when compared to more risky investments such as stocks.  Because of the safety and relatively low yield of savings bonds, inflation is a major concern.  If the interest yield paid to you is low, and inflation increases, the actual buying power of your money may end up negative.

There are many restrictions and benefits to using savings bonds as an investment vehicle.   One of the biggest benefits of savings bonds compared to other low-risk investments is that savings bonds are exempt from state and local taxes.  When balancing things like inflation verses the low yield of savings bonds and other safe investments, city and state taxes can be a huge issue especially in high tax states such as California and New York.  The other major benefit of savings bonds is that even the federal tax on the interest earned is tax free if used for educational expenses.  The other major benefit of savings bonds is simply their safety.  There is literally no other investment vehicle that is as safe for an investor, especially a US citizen.  If for some reason the federal government cannot pay off your savings bonds, there will be so many other major issues going on in the country that your savings bonds will be the least of your concerns.

There are some drawbacks to savings bonds though, the biggest is the relatively low yield.  Because of this, inflation is a major concern.  If inflation increases, the relative yield of your bonds decreases rapidly.   Also savings bonds cannot be cashed out for 1 year from their purchase date.  This makes savings bonds unsuitable for investors who are not able to commit at least one year to the investment.  Savings bonds are also non-transferable, which means you cannot sell them to another individual, they can only be redeemed by you.  Also, the most common savings bonds also apply a penalty if the bond is redeemed within 5 years.  In most cases, this penalty amounts to the interest earned in the final 3 months before the redemption.

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