If you are investing money, you should be paying attention to your rate of return, interest rate and expected yield. There are a lot of confusing numbers and jargon that go along with investing, so we are dedicating this episode to explaining a few of these terms!
A rate of return is the gain or loss on an investment over a specified time period, expressed as a percentage of the investment’s cost. Gains on investments are defined as income received plus any capital gains realized on the sale of the investment. A rate of return can be applied to any investment vehicle, from real estate to bonds, stocks and fine art, provided the asset is purchased at one point in time and produces cash flow at some point in the future. Investments are assessed based, in part, on past rates of return, which can be compared against assets of the same type to determine which investments are the most attractive.
The term yield may refer to slightly different aspects of a return for variable types of investments. For example, a yield on bonds, such as the coupon yield is the annual interest paid on the principal amount of the bond. Current yield is the coupon yield on a bond at a specific point in the time before the bond maturity. A yield to maturity of a bond is the internal rate of return on a bond’s cash flow, including the cost of the bonds, period payments from the bonds, if any, and the return of the principal at redemption.
The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. This type of interest rate is referred to as the coupon rate for fixed-income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders. In its simplest form, an interest rate is the cost of borrowing money.
The real interest rate is slightly more complex than the nominal rate, but still fairly simple. The nominal interest rate doesn’t tell the whole story because inflation reduces the lender’s or investor’s purchasing power so that they cannot buy the same amount of goods or services at payoff or maturity with a given amount of money as they can now. The real interest rate is so named because it states the “real” rate that the lender or investor receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate. If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is only 2%.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Examples provided are for illustrative purposes only. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Investing involves risk including loss of principal.
What if you had a clear formula to help you figure out how much to save… while paying down debt and enjoying life? It is possible… when you know your numbers.
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