An interest rate represents how much interest must be paid on the principal amount of a loan.
The difference between the rate of return and the interest rate is based on the nature of the returns on investments and the 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 capital. This rate is expressed as a percentage and is based on capital and annual profitability, 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 loan repayment itself.
It is often easier for someone to understand the difference between a rate of return and an interest rate by first understanding what each of these terms means. The rate of return on an investment is the percentage of loss or gain generated by an investment. This amount is based on the initial investment, or capital, 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 capital from the return and then dividing that amount by the capital to determine the rate. For an investment of $100 US dollars (USD), for example, and a return of $120 USD, capital is first subtracted from the return to determine growth of $20 USD. This amount is then divided by the capital, for a rate of return of 0.20 or 20%, which indicates the rate of return on that investment for one year.
An interest rate is an indication of the amount of interest that must 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, the annual interest rate on that loan is usually presented, 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 taking out a loan of $100 dollars, for example, and paying another $25 dollars during the year it is paid off, would divide that 25 by 100. That would give an interest rate of 0.25 or 25%. While the rate of return and interest rate are expressed as percentages, the rate of return is based on investments made while interest is paid on a loan.