If you are thinking of investing in a municipal bond, also referred to as "munis", you may be wondering if it will be a profitable investment. You may also be have questions as to how to actually invest in a municipal bond and what kind of interest you may expect to earn from the investment. There are a lot of questions regarding these types of bonds, and luckily there are clear answers for you.

What Is a Municipal Bond?

Municipal Bonds are investments made to states and local governments or even their agencies. These investments help the agencies to raise funds for a certain projects or purchases. You can usually purchase municipal bonds from any government entity such as school districts, state highway authorities, or any government entity at or below the state level. Munis are purchased by individuals, big corporations and banks through a municipal bond broker.

Is the Interest Earned on Municipal Bonds Tax Exempt?

Yes, usually the interest income earned by the municipal bondholder is exempt from state and federal taxes. That is what makes municipal bonds an attractive investment option for many people. Check with your state or broker to see if there are instances in which earned interest is taxable as there are situations in which you will have to report your interest earnings. You may also be subject to the Alternative Minimum Tax.

How Do I Invest in a Municipal Bond?

First, you should contact your broker or a municipal bond dealer that is registered with the Municipal Securities Rule-Making Board (MSRB). The broker with the MSRB will help you analyze the cost of investment by going over details such as the interest yield for certain bonds, the credit of the bond issuer, the maturity date, and other information pertaining to your possible investment. You also need to take into account that the broker will charge their fee or commission on top of the price of the actual bond. It is important to take into account the market price of the bond at the time of purchase as well as the risks. This will help you determine if the price you are getting is a fair price that will still be profitable to you in the end.

How Much Do Municipal Bonds Cost?

The average municipal bond is about $5000. Interest is earned at a fixed rate however, the current interest rate environment will determine the yield of the bond and that is where the interest rate risk comes in. Of course you can purchase bonds for more than $5000 as that can increase your potential earnings.

How Long before Bonds Mature?

Municipal bonds can be purchased for a term of as little as six months or so up to thirty years or more

Why Should I Buy a Municipal Bond?

Municipal Bonds have a better earnings opportunity than savings bonds. You can purchase a municipal bond to supplement your retirement income or to help pay for education costs for your children, all while making money in the process. Just take into account that Municipal Bonds should not be your sole source of retirement income or education expenses; they should be purchased to supplement your current savings for these big life changes.

Things to Consider before Investing in Municipal Bonds

Although the tax free interest can be enticing, you need to sit down and evaluate if it is actually a sound investment. For example, if you have an investment where you are taxed at 5% of the deal, that could still net you more money than if you invest in a tax free bond that earns less interest. You really need to compare the after-tax returns of alternative investments.

What Are the Risks in Municipal Bonds?

Municipal bonds are relatively safe investments. However there are still a few risks to take into account before investing.

(1)   You first need to evaluate the credit of the bond issuer. If it is not credit worthy, you risk not getting back the interest earned or worse, the principal. For example, this can happen when a bond issuer files for bankruptcy.

(2)   You are also at the mercy of the current interest rate. If interest rates have gone up since you purchased your bond, your bond is worth less than the actual face value. If interest rates have gone down, then your bond is worth more. When in doubt you can always hold your bond to maturity, where you will get back your principal.

(3)   Bond issuers also sometimes have the option of repaying the bond early. If they do, they will pay the investor a fee for their investment; however this can be significantly lower than the expected income from the bond.

Overall, investing in a municipal bond is typically safe with a low risk and good income opportunity. It is best to talk with a financial advisor to see if municipal bonds are a good investment for you.