Investors looking to earn income need a way to understand and compare the returns on different investments. One way you can earn income is from interest on bonds and savings accounts. Another way is to receive dividends on stocks. In either case, you can express the income as an annual rate. Annual percentage rate and dividend rate perform this function, but neither takes into account the effect of compounding.
Annual Percentage Rate
You receive interest when you lend money and shell out interest when you borrow. APR is a standardized measure of the amount of interest you’ll rake in or fork over in one year. The calculate APR, you multiply the interest per period by the number of periods per year. For example, a credit card that charges 2 percent per month would have an annual percentage rate of 2 percent times 12 months, or 24 percent per year. Lenders must always disclose the APR for credit cards and loans.
Annual Percentage Yield
APR is simple to understand, but it can understate interest because it doesn't account for compounding. For example, if you have a savings account paying 0.1 percent per month compounded, the bank will add your interest to your balance each month, increasing the amount earning interest. Annual percentage yield captures the compounding effect. The formula calls for you to raise 1 plus the interest rate per period to the power of the number of periods per year and then subtract 1. In the example, this is (( 1 plus .001) raised to the 12th power) minus 1, or 1.2066 percent, whereas the APR is 12 times 0.1 percent, or 1.2 percent.
A dividend is a cash payment to stockholders representing the payout of some profits earned by the stock-issuing corporation. Stocks that cough up dividends usually do so quarterly. The dividend rate is the total amount of dividend money per share that you’ll receive for the year. Like APR, the dividend rate turns a periodic payment into an annual amount. The main difference is that interest income, unless arising from tax-free municipal bonds, is taxed at your ordinary rate, whereas most dividends qualify for lower, long-term capital gains rates. At the time of publication, long-term capital gains rates are 20 percent, 15 percent or 0 percent, depending on your gross income.
The dividend yield allows you to easily compare the dividend income from different stocks. It’s equal to the dividend rate divided by the stock price. For example, you might have two different stocks paying dividends of $1 per quarter, giving a $4 dividend rate. However, if one stock sells for $20 a share and the other sells for $44 per share, the respective dividend yields are $4 divided by $20, or 20 percent, versus $4 divided by $44, or 9.09 percent. All other things being equal, the first stock offers more dividend income for each dollar you invest.
You can’t compare an APR with a dividend rate, because APR is a percentage and dividend rate is a cash amount per share. However, you can compare APR to dividend yield to help you choose between an investment in debt or stock. To make an apples-to-apples comparison, you must figure the after-tax return of interest and dividend income because of their different tax rates. Multiply 1 minus the appropriate tax rate by the APR or dividend yield to find the after-tax return.
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