What is the Difference Between Rate of Interest and Rate of Return?

Interest Rate:

Interest rate is the promised or specified or coupon rate of interest payable on the principal amount of the loan or the nominal value of the instrument like a bond or a fixed deposit.

For example let us consider the following picture of 9% Treasury note of the US:

Picture of 9% US Treasury Note indicating the nominal value and rate of interest

In this example:

• The principal or nominal value of the instrument is US$ 1000
• The coupon rate or rate of interest is 9%
• The annual interest receivable is US$ 90

Rate of Return:

Rate of return is the actual rate actually obtained or earned by the investor on the investment.

Can there be a difference between interest paid and actually earned by the investor? How is it possible?

Yes, indeed it is possible.

How?

Because there is what is called a secondary market for bonds, treasury notes and various other kinds of debt instruments, where these are sold at prices different from the nominal value.

For example the “9% US$ 1000 Treasury Note” can be trading at either US$1100 or US$ 800 depending on the market demand and supply. Let us examine two situations where the note is bought at US$ 1100 and 800.

Bought at US$ 1100:

• The principal or nominal value of the instrument is US$ 1000
• The coupon rate or rate of interest is 9%
• The annual interest receivable is US$ 90
• Actual cost of investment is US$ 1100
• Interest rate actually obtained or earned by the investor is (US$ 90/ 1100)*100 = 8.18%
• Rate of Return therefore is 8.18% and not 9%

Bought at US$ 800:

• The principal or nominal value of the instrument is US$ 1000
• The coupon rate or rate of interest is 9%
• The annual interest receivable is US$ 90
• Actual cost of investment is US$ 800
• Interest rate actually obtained or earned by the investor is (US$ 90/ 800)*100 = 11.25%
• Rate of Return therefore is 11.25% and not 9%
• This rate of return actually obtained is also called the yield .

Suggested Further reading:

• Yield Definition
• What is Dividend Yield?
• Yield Slide

Yield Slide

Interest Yield

Yield Definition

Meaning/ Definition:

Companies pay interest on bonds and dividends on shares on the face value (nominal value) of the instrument. When these instruments are freely traded on stock exchanges, the price actually paid by the investor for the share or bond is different from the face value. Therefore, when the interest or dividend is calculated on the actual price paid, then the return is different from the one calculated on the face value. This is the actual return or yield obtained by the investor.

Examples:

Following example illustrates interest yield on a bond:

A separate article dividend yield explains with example in the context of dividends.

Related Links:

Distinction Between Rate of Interest and Interest Yield

What is the Relationship Between a Bond's Market Price and Its Yield to Maturity?

Distinction Between Rate of Interest and Interest Yield

Every loan arrangement has following clearly specified:

1. The loan amount or principal or face value;
2. The rate of interest or coupon rate;
3. Frequency of payment of interest – quarterly or half yearly or annually;
4. Repayment terms, including:

• The date of repayment or redemption or maturity;
• Weather repayable in one shot (bullet repayment) or installments;
•  If repayable in installments:

• Frequency;

• The quantum or amount payable;

‘Rate of Interest’ is the rate at which the borrower agrees to pay interest on the loan amount or principal outstanding or the face value of the instrument.

Where the loan or loan instrument, namely bond is not tradable then the investor has no option but to hold the instrument till maturity. The borrower will repay the face value in full. During the loan period the investor will receive the interest at the specified rate of interest. In this case there is question of yield or we can express the same thing in another way that the rate of interest and yield are one and the same.

Bond Example

When a company borrows through marketable securities like bonds, interest yield comes into play, because the bond can be purchased at a price more or less than the face value. Interest yield, therefore is the rate of interest actually earned by the investor on the amount invested. Following example makes the aforesaid amply clear:

Example Showing Interest Yield

In conclusion, ‘Rate of Interest’ is the specified rate of interest on the face value of the loan or bond, whereas ‘Interest Yield’ is the rate of interest actually realized on the amount really paid for purchasing the bond in the open market.