Interest Rates and Other Measurements

Interest rates play an important role in our financial lives and our financial decision making. Having a better understanding of what different rates mean can help individuals make better decisions. Here are some definitions and comments to help you understand what the different rates mean.

Prime rate - This is the often quoted rate that many banks charge large customers for borrowing. However, many consumer borrowing tools, such as credit cards, charge interest rates that are pegged to the prime rate. The prime rate on December 31, 2005 was 7.25%. This rate changes relatively only periodically, however when the Federal Reserve raises or lower rates, this is one of the first to change.

Long-term government bond rate - This is the rate quoted for 30-year US government bonds. It represents what someone would earn if they bought one of these bonds in the open market. There is a very active market for these instruments and the rate changes daily (even minute to minute) as investors and dealers buy and sell these bonds. On December 31, 2005, long-term 30 year government bonds had a yield of about 4.5%.

Annual Percentage Yield (APY) - This term is used to identify the rate you earn when making a deposit in a checking account, savings account or certificate of deposit. It usually includes a monthly compounding factor.

Annual Percentage Rate (APR) - This is the rate you pay when borrowing money. It takes into account all of the costs of borrowing such as points with a mortgage, or lower rates for an initial period and higher rates later in the life of the loan. APR is the most important figure to consider when borrowing money. It is the best way to get a true comparison of different borrowing alternatives.

Dividend yield - This merely represents the return you would get from dividends from owning a stock. For example, if a share of stock pays a $2 dividend and the share costs $50, the dividend yield is 4%.

Total return - This term describes the entire return you get from an investment. It includes dividends and changes in the price of the underlying investment. Using the stock example quoted above, if that same $50 stock continues to pay a $2 dividend, but also increases to $55 in the course of a year, your total return would have been $7 or 14%.

If the value of that same share drops to $45, your total return would be a negative $3 or - 6%.

Time weighted internal rate of return - This measure is like "total return," but also takes into account the timing of any cash flows and assumes the cash flows are reinvested into the same investment. It can be a complicated calculation and is best used to measure returns from a total portfolio. It is the method used by mutual funds to describe their results. This website has a "Portfolio Rate of Return Calculator" in the Reference Section for your use.

Summary
Everyone wants to earn the highest returns on their money and pay the lowest rates on their borrowing. While it sounds simple, be sure to review all the terms of any savings and borrowing to make sure you understand all the details.

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