Yield Vs. Interest Rate: Understanding the Differences
If you need to borrow or lend money in your business, you will likely come across the terms ‘interest rates’ and ‘yields’. Although both of these terms are linked, there are some differences between them that all business owners should be aware of.
The interest rate is how much it costs to borrow money. In other words, it is the percentage of the borrowed amount that a lender will charge annually or in a set period until the loan is fully paid off. In many cases, you will see it quoted as the annual percentage rate.
The higher the interest rate, the more the business will pay to finish paying for the loan. Before borrowing any amount, a business must also understand the differences between compounded and simple interest and how they are calculated.
Simple interest is calculated using the amount borrowed. So, for a $1000 loan with a 10% interest rate, the business will pay the $1000 plus $100 as interest. Compounded interest is slightly more complicated because it is calculated at the end of every period with the amount used to calculate it being the principal plus the interest amount.
For the scenario above, the business would pay $100 for the first year or borrowing period, then the interest will be calculated using $1100 for the second period. This means that the borrower will pay a lot more for the same amount and if they repay the loan over a long period.
Yield is simply the return a business gets by lending money (investing in people or other businesses) or investing outright. Such investments include bonds, securities, and stocks. If your business invests in bonds as a way of diversifying its income, then you will hear the term coupon used instead. A coupon is simply a payment of interest in your investment.
When trading stocks, yields do not usually refer to the profit you get from the sale of your investment options but rather a return of dividends for the shares you or your business holds.
When you hold bonds, the yield is expressed as yield-to-maturity. This is the total amount you can expect to get from the bond once the bond matures. In this case, the yield will depend on the interest rate you agreed on with the issuer when you bought the bonds.
Yield Vs. Interest Rates: The Implications
Yields and interest rates have different implications on your business depending on whether you are investing or borrowing. When investing, a higher yield is desirable because it means you will get more money when your investment matures.
Higher interest rates mean your business will pay a lot more to borrow money. This can limit the amount you can borrow or even make it harder to repay the loan. This can affect you if you took out a personal loan or your business if you took out a business loan.
Although different businesses have different investing and borrowing needs and strategies, it is important to understand how interest rates and yields affect your business depending on how you do business. Your business might be affected by either of them, with some businesses affected by both of them, especially if they need to borrow to invest.