Yield vs. Interest Rate: An Overview

Both yield and interest rates are important terms for any investor to understand, especially those investors with fixed income securities such as bonds or CDs.

Yield refers to the earnings from an investment over a specific period. It includes investor earnings, such as interest and dividends received by holding particular investments. Yield is also the annual profit that an investor receives for an investment.

The interest rate is the percentage charged by a lender for a loan. Interest rate is also used to describe the amount of regular return an investor can expect from a debt instrument such as a bond or certificate of deposit (CD). Ultimately, interest rates are reflected in the yield that an investor in debt can expect to earn.

Yield

Yield refers to the return that an investor receives from an investment such as a stock or a bond. It is usually reported as an annual figure. In bonds, as in any investment in debt, the yield is comprised of payments of interest known as the coupon.

In stocks, the term yield does not refer to profit from the sale of shares. It indicates the return in dividends for those who hold the shares. Dividends are the investor’s share of the company’s quarterly profit.

For example, if PepsiCo (PEP) pays its shareholders a quarterly dividend of 50 cents and the stock price is $50, the annual dividend yield would be 4%.

If the stock price doubles to $100 and the dividend remains the same, then the yield is reduced to 2%.

In bonds, the yield is expressed as yield-to-maturity (YTM). The yield-to-maturity of a bond is the total return that the bond’s holder can expect to receive by the time the bond matures. The yield is based on the interest rate that the bond issuer agrees to pay.

Interest Rates

The interest rate on any loan is the percentage of the principle that a lender will charge annually until the loan is repaid. In consumer lending, it is typically expressed as the annual percentage rate (APR) of the loan.

As an example of interest rates, say you go into a bank to borrow $1,000 for one year to buy a new bicycle, and the bank quotes you a 10% interest rate on your loan. In addition to paying back the $1,000, you would pay another $100 in interest on the loan.

That example assumes the calculation using simple interest. If the interest is compounded, you will pay a little more over a year and a lot more over many years. Compounding interest is a sum calculated on the principal due plus any accumulated interest up to the date of compounding. This is an especially important concept for both savings accounts and loans that use compound interest in their calculations.

Interest rate is also a common term used in debt securities. When an investor buys a bond they become the lender to a corporation or the government selling the bond. Here, the interest rate is also known as the coupon rate. This rate represents the regular, periodic payment based on the borrowed principal that the investor receives in return for buying the bond.

Coupon rates can be real, nominal and effective and impact the profit an investor may realize by holding fixed-income debt security. The nominal rate is the most common rate quoted in loans and bonds. This figure is the value based on the principle that the borrower receives as a reward for lending money for others to use.

The real interest rate is the value of borrowing that removes the effect of inflation and has a basis on the nominal rate. If the nominal rate is 4% and inflation is 2% the real interest rate will be 2% (4% – 2% = 2%). When inflation rises, it can push the real rate into the negative. Investors use this figure to help them determine the actual return on fixed-income debt securities.

The final type of interest rates is the effective rate. This rate includes the compounding of interest. Loans or bonds that have more frequent compounding will have a higher effective rate.

Example

For example, a lender might charge an interest rate of 10% for a one-year loan of $1,000. At the end of the year, the yield on the investment for the lender would be $100, or 10%. If the lender incurred any costs in making the loan, those costs would reduce the yield on the investment.

Special Considerations

Current interest rates underpin the yield on all borrowing, from consumer loans to mortgages and bonds. They also determine how much an individual makes for saving money, whether in a simple savings account, a CD, or an investment-quality bond.

The current interest rate determines the yield that a bond will bear at the time it is issued. It also determines the yield a bank will demand when a consumer seeks a new car loan. The precise rates will vary, of course, depending on how much the bond issuer or the bank lender wants the business and the creditworthiness of the borrower.

Interest rates constantly fluctuate, with the most important factor being the guidance of the Federal Reserve, which periodically issues a target range for a key interest rate. All other lending rates are essentially extrapolated from that key interest rate.