What Is the Difference between Rate of Return and Interest Rate?

G. Wiesen

The difference between rate of return and interest rate is based on the nature of returns on investments and interest paid on a loan. Rate of return refers to a value that indicates how much return is generated based on the initial investment made, also called the capital. This rate is expressed as a percentage and is based on the capital and the annual return, which is the amount earned over the course of 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 repayment itself.

An interest rate represents how much interest must be paid on a loan's principal amount.
An interest rate represents how much interest must be paid on a loan's principal amount.

It is often easiest for someone to understand the difference between rate of return and interest rate by first understanding what each of these terms mean. The rate of return on an investment is the percentage of loss or gain generated by an investment. This value is based on the initial investment, or capital, and the amount regained over a certain period, such as one year for an annual rate of return.

The return rate can be calculated by subtracting the capital from the return, and then dividing this value by the capital to determine the rate. For an investment of $100 US Dollars (USD), for example, and a return of $120 USD, the capital is first subtracted from the return to determine growth of $20 USD. This value is then divided by the capital, for a return rate of 0.20 or 20%, which indicates the return rate on that investment for one year.

An interest rate is indicative of the amount of interest that has to be paid on a loan. It has nothing to do with any gain or loss made on an investment. When someone takes out a loan, he or she is typically presented with the annual interest rate on that loan, which indicates payment in addition to the actual principal that must be paid.

The interest rate on a loan can be determined by dividing the interest amount paid on a loan over one year by the value of the initial loan amount, or the principal. Someone taking out a loan of $100 USD, for example, and paying an additional $25 USD over the year in which it is paid back, would divide that 25 by 100. This would give an interest rate of 0.25 or 25%. While both rate of return and interest rate are expressed as percentages, a return rate is based on investments made while interest is paid on a loan.

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