Difference Between Yield and Interest Rate - Comprehensive Guide (2024)

Introduction:

The financial terms yield and interest rate are crucial for any investor, especially those dealing with fixed income securities such as bonds and certificates of deposits.

The key difference between interest rate and yield is that yield represents the profit made from investments, whereas interest rate is the cause of such profit.

Yield and interest rate are commonly used by banks, financial firms, brokers, and investment funds to attract investors. Understanding these terms helps investors make informed decisions about their investments.

Yield refers to the earnings from an investment over a specified period, including dividends and interest earned by holding certain investments. Meanwhile, the interest rate is the percentage charged by a lender for a loan. It also describes the average return an investor can expect from debt instruments such as a bond or a certificate of deposit.

Defining Interest Rate:

The interest rate on a loan is the percentage of the principal amount that a lender charges annually until the loan is repaid. For consumer lending, it is typically expressed as the annual percentage rate (APR) of the loan.

For instance, if you borrow $100,000 from a bank for one year to buy a house, and the bank charges a 5% interest rate on the loan. Besides repaying the $100,000, you would also pay an additional $5,000 in interest on the loan.

This example assumes the use of simple interest. However, if the interest is compounded, you will pay more over a year and even more over multiple years. Compound interest is an amount calculated on the initial principal and the accumulated interest up to the compounding date. This concept is crucial for both loans and savings accounts that use compound interest in their calculations.

Explaining Yield:

Yield refers to the return an investor receives from investments such as stocks or bonds, typically expressed as an annual figure. In bonds, the yield is comprised of interest payments, known as the coupon. In stocks, yield refers to the dividends received by shareholders, which is their share of the company's quarterly profit.

For example, if a company issues a dividend of $1 per share quarterly, and the stock price is $50, the annual dividend yield would be 8%. However, if the stock price increases to $100 with the dividend remaining the same, the yield is reduced to 4%.

In bond investments, the yield is expressed as yield-to-maturity (YTM), which is the total return that investors can expect when the bond matures. The yield is based on the interest rate that the bond issuer agrees to pay.

Comparing Yield and Interest Rate:

Conclusion:

Yield can be seen as the total profit earned by investing in financial products like bonds, shares, etc. It is more accurate and provides a precise understanding of the total earnings from an investment. This is because yield also considers factors such as tax benefits. To understand how yield works, one needs to first understand the concept of an interest rate.

An interest rate is simply the percentage of the amount borrowed or paid on a principal amount. For income investments like recurring deposits, fixed deposits, etc., the interest rate signifies the percentage of the amount to be earned over the initial investment made. Whereas, in terms of borrowing or lending loans, an interest rate implies the percentage of the amount to be paid by the borrower to the lender, over the total amount borrowed.

Further Reading:

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How to Calculate Total Variable Cost

Consumer Equilibrium in Case of Two Commodity

Sebi Objectives and Functions

Indigenous Banking System in India

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