What is the difference between the rate of return and the interest rate?
The difference between the rate of return and the interest rate is based on the nature of the investment returns and the interest paid on a loan. The rate of return refers to a value that indicates how much return is generated based on the initial investment made, also called capital. This fee is expressed as a percentage and is based on principal and annual return, which is the amount earned over a year. An interest rate, on the other hand, is based on additional amounts paid on a loan that are not part of the actual loan payment.
It is often easier for someone to understand the difference between rate of return and interest rate by first understanding what each of these terms means. The rate of return on an investment is the percentage of gain or loss generated by an investment. This amount is based on the initial investment, or principal, and the amount recovered over a given period, such as one year for an annual rate of return.
The rate of return can be calculated by subtracting the principal from the yield and then dividing that amount by the principal to determine the rate. For an investment of $100 USD, for example, and a return of $120, the principal is first subtracted from the return to determine the growth of $20. This amount is then divided by the principal, for a of 0.20 or 20%, indicating the rate of return on that investment over a year.
An interest rate is indicative of the amount of interest that must be paid on a loan. It has nothing to do with any gain or loss on an investment. When someone applies for a loan, they are usually presented with the annual interest rate on that loan, which indicates the payment in addition to the actual principal that must be paid.
The interest rate on a loan can be determined by dividing the amount of interest paid on a loan over a year by the amount of the loan's initial value, or principal. Someone who takes out a loan of $100, for example, and pays an additional $25 during the year it is repaid, would divide that 25 by 100. That would give an interest rate of 0.25 or 25%. Although the rate of return and interest rate are expressed in percentages, a rate of return is based on investments made during the interest payment on a loan.