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?

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

Generally a bond is issued specifying a face value, a rate of interest and the date of maturity. If there are no financial markets and the bonds purchased only by retail investors, investors would not have any option but to hold the bond till the date of maturity and receive the face value on maturity. During the life of the bond the investor would have received interest at regular intervals. This realisation of interest on the face value, also purchased at face value amounts to 'Promised Yield to Maturity'.

Existence of vibrant and flourishing financial markets add colour to otherwise boring bond investing. Large financial institutions like banks, insurance companies and mutual funds need to constantly buy and sell various investments including bonds. This creates an unbalnced demand and supply resulting in prices above or below the face value.

For those who buy the bonds in the open market , the actual interest earned is different. Interest will be higher than normal if the bond is purchased at a price lower than face value and lower if the bond is purchased at a price more than the face value.

Besides the varying interest trade in bonds in the market also results in gain or loss on Capital Invested, depending on the price paid.

Thus the market price influences the actual interest earned or 'Yield' of the bond investment. A very interesting new dimension is also added, namely capital gain or loss, similar to shares,