Yield vs Interest Rate: What's the Difference?
09 13 2017
There are plenty of examples in real estate investing of mixing up financial terms. After all, so many terms are interconnected and have similar meanings – but the distinctions are crucially important. Today, we’re clearing up the terms 'interest' and ‘yield.’
It’s a simple mix-up, one that you might compare to confusing “adverse” and “averse,” words with distinct (but similar) meanings. The distinction between these terms is often lost on audiences, which is particularly bad since it causes 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 expected – so knowing the difference is crucial to both successful real estate investors and experienced financial advisors.
What is Interest?
Generally, ‘interest’ refers to the cost of borrowing money or the potential earned amount from lent money – and it’s often expressed in reference to a period of one year. So, if you want to get specific, 'interest' can more acutely 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.For example, this is how you would calculate 6% interest on a $100,000 amount in an account:
6% x $100,000 = $6,000 total interest payable or earnedConversely, you can calculate the interest rate using the total interest and the original account total:
$6,000 total interest paid / $100,000 = 6% interest
Depending on the loan terms, interest is typically paid out monthly, quarterly, semi-annually or, less commonly, in a lump sum at the start or end of the year.
Interest Rates Measure Accruals Over 1 Year
To sum up, when a financial advisor or accountant refers to ‘interest,’ they are referring to the accruals of debt on a loan or funds in an account. Interest works multiple ways, but one thing remains the same: Interest rates measure accruals over one year.
What is Yield?
On the other hand, 'yield' is used to describe the actual forward-looking performance of money. In regards to a investments, 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.
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 |
1 |
$416.67 |
$0.00 |
$416.67 |
2 |
$416.67 |
$1.74 |
$418.41 |
3 |
$416.67 |
$3.47 |
$420.14 |
4 |
$416.67 |
$5.21 |
$421.88 |
5 |
$416.67 |
$6.94 |
$423.61 |
6 |
$416.67 |
$8.68 |
$425.35 |
7 |
$416.67 |
$10.42 |
$427.09 |
8 |
$416.67 |
$12.15 |
$428.82 |
9 |
$416.67 |
$13.89 |
$430.56 |
10 |
$416.67 |
$15.63 |
$432.30 |
11 |
$416.67 |
$17.36 |
$434.03 |
12 |
$416.67 |
$19.10 |
$435.77 |
Total Interest |
$5000.00 |
$114.58 |
$5,114.58 |
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 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. Meanwhile, if dividend payments and reinvestment of dividend payments were also included in the 'yield' calculation, the account balance would grow even faster.
Yield Describes Compounded Performance Over Multiple Years
To sum up, the yield describes compounded, forward-looking performance of an investment over multiple years. If an interest payment is only paid once, there isn’t a difference between interest and yield due to the absence of a compounding effect.
Now You Know the Difference Between Yield vs. Interest Rate
Hopefully we’ve cleared a few things up.
Interest and yield both refer to returns, but the nuances between the two are key, especially for high-net-worth individuals. When discussing with your financial advisor, client, or colleague, it’s helpful to clarify just what you mean. Familiarize yourself with the terms interest per annum, annual percentage return, and annual percentage yield. And of course – always make sure you’re on the same page.
This article was originally posted on May 26, 2016, and updated on September 13, 2017.
This article is a part of our complete guide to investing in real estate, a comprehensive resource for anyone looking to invest in real estate. Read more here.Return to News