Real vs. Nominal Interest Rates: An Overview
Interest rates are the cost of borrowing and saving money and are expressed as a percentage of the total amount of a loan or investment. They represent the total return lenders receive when they offer loans or when people put their money into savings accounts. Rates can be expressed in real or nominal terms. A real rate is adjusted to remove the effects of inflation and reflects the real cost of funds to the borrower and the real yield to the lender or to an investor. A nominal rate, on the other hand, refers to the interest rate before taking inflation into account.
KEY TAKEAWAYS
- Interest rates represent the cost of borrowing or saving, expressed as a percentage of the total amount of a loan or investment.
- A real interest rate is adjusted to remove the effects of inflation and gives the real rate of a bond or loan.
- A nominal interest rate refers to the interest rate before taking inflation into account.
- To calculate the real interest rate, you need to subtract the actual or expected rate of inflation from the nominal interest rate.
- Real interest rates represent the purchasing power of investors while nominal interest rates paint a picture of the current mood of the market.
Real Interest Rates
A real interest rate is the interest rate that takes inflation into account. This means it adjusts for inflation and gives the real rate of a bond or loan. Put simply, this interest rate provides insight into the return received after factoring in inflation. This type of rate is considered predictive when the true rate of inflation is unknown or expected.
Investors can estimate the real rate of return by comparing the difference between a T-Bond yield and a Treasury Inflation Protected Security yield of the same maturity, which estimates inflation expectations in the economy.
You can also calculate the real rate of interest associated with a credit or investment product. But you first need the nominal rate and the actual or estimated rate of inflation:
Real Interest Rate = Nominal Interest Rate – Inflation Rate
The idea that inflation has a direct impact on real interest rates is the basis for the Fisher Effect.
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