When it comes to finance, some terms may seem interchangeable, but it's important to understand the differences between very similar concepts. In most cases, when looking at investments, one evaluates the percentage of their initial investment that they might earn back over a period of time, and how that compares to other uses of this money. Interest rates and yield are similar concepts, but exist on opposite sides of the investment spectrum. Understanding the difference between yield and interest rate is essential for businesses.
Yield vs. Interest Rate
Interest rates are the fees charged, as a percentage of the magnitude, from a lender for a loan. As explained by Fidelity, when loaning money, an institution charges interest, since the value of money today is different than the value of money in five years; the percentage they choose to represent this changing value is their interest rate. Interest can also control the rate of return on some of the more stable investments, like a CD or a bond; the rate the loaning entity charges can change based on the market.
More For You
Yield is the percentage of earnings a person receives for lending money. An interest rate represents money borrowed; yield represents money lent. The investor earns interest and dividends for putting their money into a certain investment, and what they make back upon that investment is the yield. It's also expressed as a percentage.
Advertisem*nt
Article continues below this ad
So while interest rates and yield are tied to each other, Compass Credit Union explains that the terms apply to two completely different situations. You might wonder, what's the difference between yield and return? Interest rates are relevant when considering taking a loan from a lending entity; yield is relevant when considering doing the actual lending. They are, of course, related; yield for any loan needs to be comparable to a general investment interest rate, because the overall transaction needs to be profitable on both sides.
Sample Interest Rates and Yield
For example: A bank customer takes out a loan of $1,000 to purchase a computer. The bank's interest rate is 10 percent annually. This means that, after a year, the customer will owe the bank $1,000 + ($1,000 x 10%) = $1,000 + $100 = $1,100. The customer pays this back at the set interest rate.
The initial yield for the bank is the $100 they have obtained with the $1,000 they loaned. However, if this transaction cost them $5 in bookkeeping and $15 in hours worked managing this loan, the actual yield is $100 - $20 = $80.
Advertisem*nt
Article continues below this ad
So the yield and interest rate are related; the yield will at best be equal to the interest rate, providing a return at the same percentage point the borrower is willing to pay. In reality, however, yield percent can be lower than interest rate, because the loaner may incur additional costs in managing the loan.
Making Related Business Decisions
For a business looking at the market to determine options, it's important to understand the rates and how they interact. If a company feels that it can generate more value by investing money into a higher-yield opportunity, they may do so, but that means the money is tied up in an external investment, rather than acting as a reinvestment into the company.
Likewise, if the company feels like interest rates are low enough, they may decide to borrow money to invest into the company, and take the risk of seeing what sort of yield will emerge from a capital investment.
Advertisem*nt
Article continues below this ad
