The Difference between Interest and Yield
24 May 2016
Within many financial circles, the terms 'interest' and 'yield', are improperly used synonymously. Consequently, the distinction between these terms is often lost on audiences, causing a general misunderstanding of how their money is working for them. From the standpoint of growing wealth, how each term functions directly impacts the level of monetary growth that can be experienced.
What is INTEREST?In general, 'interest' refers to the cost of borrowing money or the potential earned amount from lent money. Interest is often expressed in the period of one year. Therefore, 'interest' can more accurately be identified as interest per annum or annual percentage return. During a 12 month period interest will accrue to an amount equal to a particular interest rate of a balance owed or lent.
This is an example of accruing 6% interest on a $100,000 amount in an account:
6% x $100,000 = $6,000 total interest payable or earned
Depending on the loan terms, this interest is typically paid out monthly, quarterly, semi-annually or, less commonly, in a lump sum at the start or end of the year.
Conversely, the interest rate can be ascertained by dividing the total amount paid in interest by the original loan amount.
$6,000/$100,000 = 6% interest
What is YIELD?On the other hand, 'yield' is used to describe the actual forward-looking performance of money. In regards to an investment, the 'yield' is how much profit was actually gained. Yield takes into account 'interest', the compound effect of reinvesting the interest along the way, and if applicable, dividends. With the compounding effect, the principal balance would earn interest on interest earned.
Like interest, yield is also expressed in annual terms – therefore, it is also commonly referred to as annual percentage yield.
Take note, over one year, if an interest payment is only paid once, there would not be a difference between interest and yield due to the absence of a compounding effect.
However, below is an example of calculating yield based on a $100,000 balance in an account that has a 5% annual interest rate with interest payments made monthly. In this example the interest payments are reinvested at the same interest rate of 5%.
|REINVESTMENT OF INTEREST|
|Month||Payment||Interest on Payment||Total Earned|
In this example, although the interest rate is 5%, the annual percentage yield is 5.11%. This percentage difference may seem negligible. However, with larger balances and over a wider span of time, the compound earnings can create significant account growth. If dividend payments and reinvestment of dividend payments were also included in the 'yield' calculation, the account balance would grow even faster.
If all variables remained constant, although the 'interest' and interest payments would constant, the overall 'yield' would continue to grow and make a huge difference in growing wealth.
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