- Interest and dividends are among the simplest and safest ways to earn steady investment income.
- Interest is money earned for lending your money and offers a guaranteed rate of return.
- Stock dividends are paid regularly by companies, but run the risk of being cut or suspended.
- Read more stories from Personal Finance Insider.
There are a multitude of ways to try to make money in today’s markets, whether you’re investing in blue chip stocks, a money-market fund, or the latest cryptocurrency craze. There are also simpler and safer choices, such as interest and dividends.
Interest and dividends can both help investors tap into a steady stream of income while mostly avoiding the market
associated with riskier investments like stocks. Still, there are key distinctions between the two that are important to understand and that could affect your decision-making.
Table of Contents
interest vs. dividends: At a Glance
Both interest and dividends are ways investors can produce consistent income from their portfolios without having to actively manage their holdings. They do so in different ways.
- interest: The cost of borrowing money, expressed as a percentage, that’s paid to the lender. It also represents periodic coupon payments offered to investors who buy debt securities such as bonds.
- Dividends: A portion of a company’s profits that it distributes at regular intervals to shareholders who buy partial ownership of a company through equity securities such as stocks. Also paid to consumers in the form of an annual percentage yield (APY) for those who store their money in checkings and savings accounts at a bank.
What is interest?
Most people are probably more familiar with the concept of interest as it relates to borrowing money in the form of a mortgage or auto loan.
When buying a car, a home, or some other big-ticket item, chances are you took out a loan that required you to pay interest, usually at an annual rate defined as a percentage. That interest is the cost of borrowing the money you needed to pay for that new Tesla or Apple MacBook Pro. That’s how banks earn money by lending.
It’s also how investors make money through interest. When you lend your money to a bank through deposits, in a basic savings account or certificate of deposit (CD), you earn interest on that money that is both guaranteed and protected by government agencies like the Federal Deposit Insurance Corp., or FDIC.
But interest can also be earned through fixed-income securities like bonds. Investors debt securities, such as bonds, in exchange for a guaranteed stream of steady, periodic income through interest payments (also known as coupon payments). Corporate bonds and US Treasury bonds are prime examples, but there is a wide variety of debt securities to choose from.
Interest can also be calculated as simple or compound.
is only applied to the principal, or original amount of money borrowed or deposited.
, meanwhile, takes previously earned interest and adds it to the principal. From an investment standpoint, compound interest is desirable as your investment will grow over time.
Ken Tumin, founder and editor of DepositAccounts.com, notes that interest investing is considered a very conservative approach because the return is low and often struggles to keep up with inflation.
“If you’re looking for a long-term horizon, it’s recommended to look at something more aggressive,” Tumin says.
While guaranteed and predictable returns are appealing, relying on interest payments often requires investors to tie up their money for long, fixed terms. That means they’re unable to adjust quickly to major market swings that might otherwise provide greater returns.
Example of how interest works
To see how interest works, let’s take a look at a basic certificate of deposit (CD) that’s offered by banks.
Investing $1,000 in a one-year CD at a rate of 3% would yield $30 in simple interest over the term, plus your initial $1,000 investment. Not the greatest return, but it’s guaranteed.
To get a sense of how compound interest would work on a similar CD, let’s adjust some of the terms. If we invest that same $1,000 in a five-year CD with compound interest at the same 3% rate, it would yield $159.27 in interest over the term. The return after the first year is the same as our original example, $30 in interest. But since it’s compounding, that $30 gets added to the principal amount and the 3% interest is earned off that $1,030. So in year two you’ve earned $60.90 in interest, and so it goes through the five-year term of the CD.
Use our compound interest calculator to see how quickly earnings can add up
Your balance after 5 years
What are dividends?
Dividends are a discretionary distribution of a company’s earnings to investors. They’re usually cash payouts paid on a per-share basis to shareholders either quarterly or annually. Dividends are determined by a company’s board of directors.
Not all companies pay dividends. Those that do are usually well established and financially stable such as Exxon, Apple, Home Depot, or Citigroup. In order to qualify for a dividend, you must have purchased a company’s stock at least one business day before the exdividend date. Some companies have preferred shares, which come with limited or no voting rights but usually have guaranteed fixed dividends.
Dividends are similar to interest in that an investor is being paid for an initial outlay of their own money. But instead of buying a CD or bond, they’re buying partial ownership of a company and a right to a portion of its profits through a dividend. Dividend payments often amount to more than one could earn through interest.
While the price of a company’s stock can swing widely, the dividends it pays typically do not fluctuate nearly as much, making it a reliable source of income in most cases. Investors can also take their dividends and reinvest them in additional shares of the company, allowing them to compound their returns.
Jerremy Newsome, chief executive officer of trading education platform Real Life Trading, says dividends are akin to a bonus on top of whatever returns your initial investment in a stock has already realized.
“I very rarely invest in a company just because it pays dividends,” Newsome says. “Dividends, to me, is kind of like getting a really delicious chocolate cake, and then the waiter also included a cherry. I like cherries, so I’ll eat it. But it wasn’t the main purpose of me buying dessert. “
The risk however, is that the cherry can be smaller than you expected, or doesn’t come at all. That’s a key difference between interest and dividends. Interest payments are guaranteed, while dividends are at the discretion of the board of directors and usually dependent on the company’s financial standing.
Example of how dividends work
Let’s say you bought 1,000 shares of Citigroup on Jan. 3, a little less than two weeks before the bank reported fourth-quarter results. The company then declares a dividend of 51 cents per share on the day it releases its results, noting in the announcement that the dividend will be payable on Feb. 25th to stockholders of record on Feb. 7.
Since you bought your 1,000 shares earlier in the year you are a stockholder of record. Therefore, you’re entitled to 51 cents for every share you own. That amounts to a cash payment of $510. You could then pocket that money, or you could use it to buy additional dividend-paying shares.