Almost every area of your financial life is impacted by the interest rate. Money saved in a bank account or invested in bonds accrues interest. Interest is a cost you incur when you take out a loan. The rate you wind up paying is determined by a number of factors, some of which are unstable over time.
Each interest rate has two names; the nominal rate and the real rate. For simplicity’s sake, let’s say that a savings account promises a 2% yield; the interest rate promoted to customers is the nominal rate.
The real rate is typically less than the nominal rate because it takes inflation into account. It’s vital to grasp since it gives a more precise picture of the worth of the money you spend or earn in interest.
Nominal vs. Real Interest Rates
Real interest rates and nominal interest rates both describe the cost of borrowing or the return you get from lending money. However, real rates adjust nominal rates for the impact of inflation, which generally reduces the spending power of money over time.
Real Interest Rates
- Reflects the true purchasing power of the dollars you earn from savings or pay on a loan
Nominal Interest Rates
- Not inflation-adjusted
- Reflects the numeric dollar amount paid or received
Real Interest Rates
When inflation is taken into account, nominal interest rates become more accurate measures of real interest. It’s straightforward to determine real rates by doing the following: To get the effective interest rate on a loan, bond, or savings account, one need only deduct the annual inflation rate from the nominal interest rate.
Real rates can be negative even though nominal rates are positive. If the inflation rate is 4% and you acquire a loan with a nominal interest rate of 2%, the real interest rate you pay is -2%.
Deflation is the antithesis of inflation. If inflation is low enough, money actually appreciates rather than loses purchasing power. For this reason, real interest rates are calculated by adding the deflation rate to the nominal interest rate, rather than subtracting the inflation rate as is traditionally done.
If you take out a loan with a nominal interest rate of 5% and the deflation rate is 3% (equal to an inflation rate of -3%), the effective interest rate will be 8%.
The Measures of the Real Interest Rate
The purchasing power of money in circulation is reflected in real interest rates. Suppose there was no inflation in the globe. If you borrow $100 from a friend at the start of the year and pay it back in full by the end of the year, your friend will get back the full $100 plus interest.
So, $100 buys precisely the same amount of stuff now as it did a year ago. Picture the same a friend lends you $100 interest-free, but there’s a 5% annual rate of inflation. That same $100 would be worth $5 less at the year’s conclusion than it was at the year’s beginning. Your pal is treated unfairly.
Your acquaintance will have to charge a real interest rate high enough to keep up with inflation if they want to make a profit. That’s at least 5% interest, and if they were serious about making money, they’d charge substantially more.
Rates of Nominal Interest
A savings account, investment, or line of credit’s nominal interest rate is the rate at which it is initially offered. Since it does not have to take inflation into account, which varies over time and can be difficult to compute, it is simple to measure.
Lenders and banks have a hard time planning for the future in terms of inflation rates due to inflation’s volatility and monthly fluctuations. Therefore, it is extremely problematic, if not impossible, to promote true real interest rates (therefore, nominal rates).
What Nominal Interest Rates Indicate
The rate of return on your savings or investments, or the interest a lender receives on a loan, is measured in terms of a nominal interest rate. If you borrow $100 for a year at a 5% interest rate, you will owe the lender $105 when the loan is due.
Money is money, regardless of how much it can buy. In order to fully repay your debt, you need to pay the lender $105 just.
What Interest Rates Mean for You in Real and Nominal Terms
It is essential for savers, investors, and borrowers to be aware of the difference between real and nominal interest rates. You should take inflation into account while making financial decisions because it has a significant effect on the purchasing power of your money.
To calculate how much money you’ll owe a lender, you can utilize nominal interest rates, which are helpful for borrowers. To calculate how much money you will have to pay back for a loan over time, you need to know the nominal interest rate.
Because it more accurately reflects the genuine cost of borrowing money, the real interest rate is helpful. In general, inflation has a negative effect, meaning that money is becoming less valuable over time.
Borrow $1,000 for a year at 5% interest, and you’ll have to come up with $1,050 to cover both the principal and the interest.
With an inflation rate of 2%, a real interest rate of 3% is achieved. This payout of $1,050 is equivalent to $1,030 in purchasing power at the start of the year. That translates to a loss of $30 in purchasing power as a result of the borrowing.
When real interest rates go below zero, the nominal interest rate has fallen below the rate of inflation. When you repay a loan, the amount you borrowed increases in purchasing power.
Using nominal interest rates, investors can compute their actual return over a set period of time. If you buy a bond with a 5% nominal interest rate, for instance, you can calculate the exact amount you’ll get back when the bond matures by using a simple compound interest formula.
Nonetheless, real rates may be even more crucial to investors. You can figure out how much money you’ll actually make from an investment if you know the true rate of return. It’s not as crucial to come out ahead in terms of raw cash amounts as it is to make sure that each dollar actually buys more than it did before.
Because of this, most investors view inflation as a negative. The rate of return at which your purchasing power begins to increase, known as the breakeven point, is higher in an environment with a strong inflation.
A return on investment of 11% per year, for instance, appears to be rather profitable on paper, as it is higher than the average rate of return for the S&P 500 index. Your real increase in purchasing power, however, will be only 2% if the yearly inflation rate is 9%. Not really interesting.
If you want to know the true cost of borrowing money or the true return on your investment, you must be familiar with real interest rates. Fortunately, the math is straightforward. When calculating real rates, just remove inflation from nominal rates.
The Consumer Price Index is one of many indicators of inflation used in the United States (CPI). By deducting the Consumer Price Index inflation rate from nominal interest rates, you can get a decent understanding of the real interest rate for a loan or investment and whether or not it is a good opportunity.