Yield vs Interest Rate: Meaning, Formula, and Practical Examples
The difference between yield and interest rate is an essential topic in financial management. It is especially important for students preparing for Commerce school or competitive exams, and for anyone trying to understand investments and loans. Knowing this concept helps in making smarter financial decisions in daily life and business activities.
| Parameter | Yield | Interest Rate |
|---|---|---|
| Definition | Actual return earned on an investment (percentage of current value) | Fixed percentage charged by lender or offered by issuer (percentage of principal) |
| Applies To | Bonds, FDs, shares, debentures | Loans, bonds, FDs, credit cards |
| Formula | Yield = (Income from investment / Current market value) × 100 | Interest = (Principal × Rate × Time) / 100 |
| Nature | Variable, depends on price & reinvestments | Usually fixed (especially for bonds/loans) |
| Example | Yield on a bond after price changes | Interest rate charged on a bank loan |
Difference Between Yield and Interest Rate
Yield and interest rate are both related to returns on money, but they are not the same. Understanding their distinction is crucial for students and investors. The topic frequently appears in board exams, competitive tests like CA and banking, and real-world business scenarios.
What is Yield?
Yield is the actual return an investor earns from an investment over a specific period. It considers total income received (interest, dividends) divided by the investment’s current market price or value. Yield is affected by market price changes, maturity period, and reinvestment of earnings.
Types of Yield
- Current Yield (for bonds and FDs)
- Yield to Maturity (YTM for bonds)
- Dividend Yield (for stocks)
- Effective Yield (considers compounding)
Yield Formula Examples
- Current Yield for Bonds:
Yield = (Annual interest income / Current bond price) × 100 - Dividend Yield for Shares:
Yield = (Annual dividend per share / Market price per share) × 100
Example: If a bond pays Rs. 100 interest annually and is currently selling for Rs. 950, its current yield = (100/950) × 100 = 10.53%. If a share pays Rs. 5 dividend and is priced at Rs. 100, dividend yield = 5%.
What is Interest Rate?
Interest rate is the fixed percentage charged by a lender on the principal amount or paid by an issuer (like a company or bank) to a depositor or bondholder. Interest rates are set in advance and remain constant for the period (unless floating/rising rate products are used).
Types of Interest Rates
- Simple Interest Rate
- Compound Interest Rate
- Coupon Rate (for bonds)
- Annual Percentage Rate (APR)
- Nominal and Effective Rates
Interest Rate Formula
Interest (Simple) = Principal × Rate × Time / 100
Example: If you borrow Rs. 20,000 at 10% per annum, annual interest = Rs. 2,000 (20,000 × 10% × 1). In a fixed deposit, the interest rate represents your annual earnings on your principal.
Yield vs Interest Rate: Key Differences
| Yield | Interest Rate |
|---|---|
| Return earned on current market price | Return calculated on initial invested or loaned amount |
| Subject to change due to price fluctuations and reinvestment | Usually fixed at the start of the contract |
| Reflects actual earnings, can be more/less than interest rate | Does not consider reinvestment or market price change |
| Seen in investments (bonds, shares, debentures) | Common in loans, deposits, bonds |
Practical Examples: Yield and Interest Rate
Example 1: Bonds
A bond has a face value of Rs. 1,000 and a coupon rate (interest rate) of 8%. The annual interest you receive is Rs. 80. If the bond is trading at Rs. 900, yield = (80/900) × 100 = 8.89%. Here, the yield is higher than the coupon rate because the bond price is lower than the face value.
Example 2: Fixed Deposits (FDs)
If an FD of Rs. 10,000 is placed at 6% interest for one year, you earn Rs. 600. If the bank offers monthly payouts or compounding, the effective yield may be slightly higher due to reinvestment.
Example 3: Stocks
If a company pays Rs. 2 per share in annual dividends and its share price is Rs. 40, dividend yield = (2/40) × 100 = 5%.
Why the Difference Between Yield and Interest Rate Matters
Understanding the difference between yield and interest rate helps in investment planning, reading financial statements, and preparing for exam questions. It is also used in ratio analysis and making choices among investment products.
The distinction is frequently tested in Commerce board exams and helps in analyzing real-world products like mutual funds, bonds, fixed deposits, and loans. Knowing the actual yield lets you assess which investment is best, beyond what interest rates or coupons suggest.
To learn more about related financial performance measures, see Return on Investment and Return on Equity and for calculation help refer to Yield Rate Formula.
Summary
Yield is the real return on investment, affected by price and time, while interest rate is the fixed rate set by lenders or issuers. Understanding both is crucial for students, investors, and professionals. Mastering this difference is essential for Commerce exams and financial planning. Vedantu simplifies such Commerce topics for better learning and exam success.
FAQs on Difference Between Yield and Interest Rate
1. What is the main difference between yield and interest rate?
Yield represents the actual return an investor receives on an investment, while the interest rate is the predetermined percentage charged or paid on the principal amount. Yield considers factors like market price and time, unlike the fixed interest rate.
2. What is the difference between yield and effective interest rate?
Yield reflects the total return an investor earns, incorporating all payments and market price changes over time. The effective interest rate, however, focuses solely on the interest earned, considering the effect of compounding. Therefore, while related, they are not interchangeable.
3. What is the difference between interest rate and dividend yield?
Interest rate is the percentage return on debt investments like bonds or fixed deposits. Dividend yield, on the other hand, represents the return on equity investments, calculated as annual dividends per share divided by the share price. They measure returns on different asset classes.
4. What is the difference between interest rate and annualised yield?
The interest rate is a fixed percentage, typically stated annually. The annualised yield, however, expresses the total return as an annual rate, considering compounding or reinvestments over the investment period. It provides a standardized yearly comparison.
5. How is yield calculated for bonds compared to interest rate?
A bond's interest rate (or coupon rate) is fixed at issuance. Bond yield, however, is calculated by considering both the coupon payments and the current market price of the bond. Therefore, yield fluctuates with market conditions, unlike the fixed interest rate.
6. What is an annualised yield?
Annualised yield is the annual rate of return on an investment, considering the effect of compounding or reinvestments over the investment's total duration. It helps standardize returns across different investment horizons.
7. Is yield always higher than the interest rate?
No. The relationship between yield and interest rate depends on several factors, including the market price of the investment and the timing of payments. Yield can be higher, lower, or equal to the interest rate.
8. What is the difference between yield, coupon rate, and interest rate in bonds?
The coupon rate is the stated annual interest rate on a bond. The interest rate refers more broadly to the cost of borrowing. Yield, however, is the total return, reflecting both coupon payments and changes in the bond's market price.
9. How do interest rate changes affect bond yield in the secondary market?
Changes in market interest rates directly impact bond yields. When market interest rates rise, existing bond prices typically fall, increasing their yield. Conversely, when market interest rates fall, bond prices rise, decreasing their yield.
10. How is yield different for stocks (dividend yield) versus bonds?
Stock yield (specifically dividend yield) is based on dividends paid relative to the stock's market price. Bond yield incorporates both coupon payments and changes in the bond's market price until maturity. They represent returns from distinct asset classes.
11. What is the relationship between nominal and effective interest rates?
The nominal interest rate is the stated rate, without considering compounding. The effective interest rate accounts for the effect of compounding over a given period, reflecting the actual interest earned. The effective rate will generally be higher than the nominal rate.
12. Can investment yield ever be negative?
Yes, an investment can have a negative yield if the market price of the asset falls more than the income or payments received from the investment during the period.
13. Why do financial institutions use yield instead of just interest rate for marketing products?
Financial institutions often use yield in marketing because it represents the actual return an investor receives, considering all factors including the market price and timing. This allows for a more accurate and comprehensive comparison of investment products than simply using the interest rate.
