Determining When & Why Dividend Income Vs Interest Income Is The Best Choice
I would like to address a common question about dividend investing today. Specifically, are dividends better than interest?
And like so many questions, the answer will depend on your investment goals and risk tolerance.
However, I can give you some tips on when investing for dividend income vs interest income is the better choice.
So, let’s get moving, by addressing the answer to today’s question right up front…
Are Dividends Better Than Interest?
I believe there are 3 cases when dividends are better than interest…
First, dividends are better than interest when an investor seeks growth of their investment income over time.
Second, a qualified dividend is better than interest because it receives favorable tax treatment.
Finally, high-quality dividend investments provide the opportunity for capital appreciation. While income investments normally do not.
There you have the high-level answer to today’s question. However, we need to dig a little deeper.
First, with some brief background information. Then by going into the details that support today’s answer.
Let’s do it…
Disclosure: At no cost to you, I may get commissions for purchases made through links in this post.
What Is Interest Income?
First of all, interest income is earned by lending your money to another party, a borrower.
In exchange for the use of your funds. The borrower pays you, the lender, interest.
The borrower also agrees to return your cash, the principal balance, at a later date. This is the original amount of money you loaned to them in the first place.
The amount of interest income is determined by the interest rate agreed upon by the two parties involved.
Generally speaking, the longer the term of the loan. And the greater risk the lender will not receive his or her money back. The higher the interest rate will be.
The repayment of the principal balance. And the payment of interest. Both are part of a legally binding agreement.
Typical examples of interest-bearing investments include:
- Savings accounts
- Certificates of deposit
- Peer-to-peer loans
- Bonds
Continuing, you may be wondering, are dividends the same as interest? The direct answer is no.
So, allow me to set our definition of dividends…
What Are Dividends? (also called dividend income)
For today’s discussion, dividends are cash distributions to shareholders of a company’s stock.
Furthermore, they are typically paid quarterly. However, some companies choose to pay dividends only once or twice per year.
Most importantly, a business is not required to pay a dividend. Nor, as an investor in stock, is there a legally binding agreement that your original investment will be returned.
But, don’t let either of these two points scare you off.
Because there are plenty of companies with good dividend yields. Also, having paid continuous dividends for decades.
And during the same time, they have generated large increases in their share price. All for the benefit and safety of shareholder investments.
Finally, for tax purposes, dividends are classified in one of two ways: qualified or ordinary.
Qualified dividends are taxed at lower rates than ordinary dividend income.
I don’t want to bore you with the tax laws today…
So, suffice it to say if you buy and hold most U.S.-based corporations’ stock. Then you will usually (but not always) receive a qualified dividend.
Which is taxed at a lower rate. Versus interest income.
I suggest you consult with a tax professional. When you are uncertain about whether a company’s stock of interest pays a qualified dividend, or not.
Okay. Next, the moment you have been waiting for.
As we probe more deeply into interest income vs dividend income…
3 Cases When Dividends Are Better Than Interest
As I see it, earning dividends is better than interest when your investment objectives align with one or more of the following three situations…
1. Preferential Tax Treatment
First, you desire to pay fewer taxes on your investment income.
Since qualified dividends receive preferential tax treatment. And are taxed at a lower rate. After taxes, you will be better off with dividends vs interest.
Because after taxes, a dollar of dividend income will be worth more than a dollar of interest income.
Understand that this is a “rule of thumb”. And generally holds.
On the other hand, tax laws are complicated. And everyone’s tax situation is a little different.
As a result, I can’t offer “one size fits all” guidance. And once again, it’s a good idea to talk with your tax accountant. To understand your exact situation.
But, I will repeat what I said earlier. Because it’s important…
After tax, a dollar of dividend income is worth more. When compared to a dollar of interest income.
Here is the second reason dividend income is better than interest income…
2. Potential For Dividend Growth
You want your dividend income to grow over time. Without having to make additional investments.
Many companies that pay dividends vs interest, increase their dividend rate per share annually.
Thus, by investing in and holding stock of a company that follows this practice. Your potential dividend income next year will be greater than your dividend income this year.
Best of all, you don’t have to do anything. Just buy and hold what is commonly referred to as a dividend growth stock.
On the other hand, interest rates on interest-bearing investments are typically fixed.
Meaning you will receive the same amount of interest income each year. Until your principal is returned.
This is why interest-bearing assets and the income they produce. Are sometimes referred to as “fixed income” investments.
Simply because the interest income you receive doesn’t change. It’s fixed.
Do you need to find some good dividends vs interest for your portfolio?
Then you may enjoy the Simply Investing Report and Analysis Platform. An interactive database that is full of recommendations on the best dividend stocks and when to buy them.
Last, but not least. The third reason that makes dividends better than interest…
3. Opportunity for Capital Gains
You want your original investment to increase in value over the long run.
Because by investing in high-quality dividend-paying stocks. History tells us, that the value of their stock price increases over time.
Creating what is known as capital gains in addition to the dividends received.
On the other hand, what is the best case scenario for the original principal you lent out in exchange for earning interest income vs dividend income?
It is getting the same amount back that you loaned out to another party. Plus the agreed-upon interest.
Thus, there is no opportunity for capital gains coming along with your interest income.
Ready to invest for capital gains? Then check out the stock recommendations from the Motley Fool Stock Advisor.
Are dividends better than interest? It might seem that way. But not so fast.
Allow me to address the obvious question. Because if dividends vs interest have all of these advantages, then…
Why Would Anyone Choose Interest Vs Dividends?
Why would an investor choose an interest-bearing investment versus putting their money in a dividend growth stock?
The answer to this question is simple.
It is the risk involved with stocks and the stock market. An important reason why some investors do not buy dividend stocks.
Referencing back to our definitions of what is interest income? And what are dividends?
Remember that the borrower has entered into a legally binding agreement. Requiring him or her to pay you interest and give your original loan amount back at a predetermined time.
On the other hand, if a dividend-paying company falls on hard economic times. They have no obligation to continue paying their dividend. And you will likely lose some or all of your original investment too.
As a result, we are talking about the basic risk-reward tradeoff that investors face daily as they pursue income from investments.
Okay. That’s all I have.
So, please allow me to close with a few parting thoughts…
Are Dividends Better Than Interest?
Dividends are better than interest for 3 primary reasons:
- Preferential tax treatment
- Potential for dividend growth
- Opportunity for capital gains
However, these advantages come with no guarantees. And a greater possibility for risk of loss.
Although, in my humble opinion, I think the risk is minimal. Compared to the potential for solid long-term investment returns and compounding cash flows from dividend-paying stocks.
On the other hand, interest-bearing assets that pay a fixed interest income are better for risk-averse investors. Or, money that is part of a broader portfolio for diversification purposes.
Have you been debating whether to invest for interest vs dividends? Now you can decide for yourself.
Thus, it’s time to close out.
Thanks for reading. I hope you found value in this article.
If so, you may like to check out more of our…
Good Reads About Dividend Investing
Author Bio: Tom Scott founded the consulting and coaching firm Dividends Diversify, LLC. He leverages his expertise and decades of experience in goal setting, relocation assistance, and investing for long-term wealth to help clients reach their full potential.