Paper I bonds are a type of savings bond issued by the U.S. Treasury that earn interest based on a combination of a fixed rate and a semiannual inflation rate. They are designed to protect the value of your money from inflation over time.
Understanding the Mechanics of Paper I Bonds
When you own a paper I bond, its value grows over time through the accrual of interest. Unlike traditional bonds that pay interest out regularly, the interest on an I bond is added to the bond's principal value.
Here's a breakdown of how the interest accrues and compounds:
- Monthly Interest Accrual: I savings bonds earn interest monthly. This interest is calculated based on the bond's composite rate (a combination of the fixed rate and the inflation rate) and applied to the bond's principal value for that month.
- Semiannual Compounding: While interest is earned monthly, it is compounded semiannually. This means that every 6 months we apply the bond's interest rate to a new principal value. The new principal is the sum of the prior principal and the interest earned in the previous 6 months. This compounding effect allows the bond's value to grow faster over time as interest is earned on previously earned interest.
The Compounding Process in Action
Let's visualize the compounding effect:
| Period | Starting Principal | Interest Earned (6 Months) | New Principal (for next 6 months) |
|---|---|---|---|
| Months 1-6 | Original Principal | Interest on Orig. Principal | Orig. Principal + 6 Months' Interest |
| Months 7-12 | New Principal | Interest on New Principal | New Principal + Next 6 Months' Interest |
| ... | ... | ... | ... |
This process continues for the life of the bond, which can be up to 30 years. The value of the bond is its principal plus all the accrued interest that hasn't been paid out (because it's added to the principal).
Key Aspects of Paper I Bonds
- Purchase: Paper I bonds could typically be purchased through tax refunds using IRS Form 8888 or Form 1040 Schedule L. Direct purchases online are for electronic bonds.
- Term: I bonds earn interest for up to 30 years.
- Redemption: You can cash in paper I bonds at most banks after holding them for at least 12 months. If you cash them in before 5 years, you forfeit the last three months of interest.
- Value: The current value of a paper I bond isn't printed on it. You need to use the TreasuryDirect website's Bond Value Calculator to find its up-to-date value, which reflects the principal plus all accrued interest.
- Interest Rate: The composite interest rate for I bonds changes every six months (on May 1st and November 1st). It combines a fixed rate (set when you buy the bond and remains the same) and an inflation rate (which changes).
Understanding how the monthly interest accrual and semiannual compounding work is key to seeing how your investment in paper I bonds grows and helps protect your savings from inflation.
