While they are related and often used interchangeably, the interest rate and yield aren’t technically the same thing.
Simple Explanation Using Bonds
The interest rate is the fixed percentage of the bond’s face value (the amount it’s worth when it’s issued) that the bond issuer agrees to pay to the bondholder every year.
It’s also known as the coupon rate. For example, a bond with a face value of $1,000 and an interest rate of 5% would pay $50 in interest each year.
The yield of a bond is the total return an investor can expect if the bond is held until it matures.
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Yield takes into account both the annual interest payments and any difference between the price the investor paid for the bond and the face value that will be paid back when the bond matures.
Because bond prices can change after they’re issued (if they’re bought and sold in secondary markets), an investor may pay more or less than the face value for a bond, which can affect the yield.
Simple Explanation Using Loans
In the context of a loan, the interest rate and the yield can often be considered the same, especially for a straightforward, fixed-rate loan where the borrower makes all payments on time and in full, and there are no additional fees involved.
The interest rate of a loan is the percentage of the loan amount (the principal) that the borrower must pay back, in addition to the loan amount itself.
The yield, often referred to as the annual percentage rate (APR) in the context of loans, can also include other costs associated with the loan, such as origination fees or early repayment charges.
The APR provides a more complete picture of the true cost of borrowing.
So, if a loan has no additional fees and the interest is compounded annually, the interest rate and yield (APR) could be effectively the same.
However, if there are additional costs or if the interest is compounded more frequently (which effectively increases the cost of the loan), the APR may be higher than the nominal interest rate.
In a nutshell, while both terms – interest rate and yield – relate to the returns an investor can get, the interest rate only considers the annual interest, while the yield takes a more comprehensive view.