Loading the player...

What is a 'Real Interest Rate'

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate:

Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)

BREAKING DOWN 'Real Interest Rate'

While the nominal interest rate is the interest rate officially assigned to the product or investment, the real interest rate is a reflection of the change in purchasing power derived from an investment based on shifts in the rate of inflation. The nominal interest rate is generally the one advertised by the institution backing the loan or investment. By adjusting the nominal interest rate to compensate for inflation, you are identifying the shift in purchasing power of a given level of capital constant over time.

Expected Rate of Inflation

The anticipated rate of inflation is reported by the U.S. Federal Reserve to Congress regularly and includes estimates for a minimum three-year period. Most anticipatory interest rates are reported as ranges instead of single point estimates. As the true rate of inflation may not be known until the time period corresponding with the holding time of the investment has passed, the associated real interest rates must be considered predictive, or anticipatory, in nature when the rates apply to time periods that have yet to pass.

Effect of Inflation Rates on the Purchasing Power of Investment Gains

In cases where inflation is positive, the real interest rate is lower than the advertised nominal interest rate. For example, if funds used to purchase a certificate of deposit (CD) are set to earn 4% in interest per year and the rate of inflation for the same time period is 3% per year, the real interest rate received on the investment is 4% - 3% = 1%. The real value of the funds deposited in the CD will only increase by 1% per year, when purchasing power is taken into consideration.

If those funds were instead placed in a savings account with an interest rate of 1%, and the rate of inflation remained at 3%, the real value, or purchasing power, of the funds in savings will have actually decreased, as the real interest rate would be -2%, after accounting for inflation.

RELATED TERMS
  1. Nominal Interest Rate

    The interest rate before taking inflation into account. The equation ...
  2. Real Rate Of Return

    The annual percentage return realized on an investment, which ...
  3. Fisher Effect

    An economic theory proposed by economist Irving Fisher that describes ...
  4. Nominal

    An unadjusted rate, value or change in value. This type of measure ...
  5. Nominal Rate Of Return

    The amount of money generated by an investment before expenses ...
  6. Inflation-Protected Security - ...

    A type of fixed-income investment that guarantees a real rate ...
Related Articles
  1. Investing

    Interest Rates Explained: Nominal, Real, Effective

    Interest rates are divided into subcategories. Smart investors look beyond the nominal or coupon rate of a bond or loan to see if it fits their objectives.
  2. Insights

    What's a Real Rate of Return?

    A real rate of return is an annual percentage investment return that’s adjusted for inflation, taxes or other factors.
  3. Investing

    Understanding the Fisher Effect

    The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.
  4. Insights

    Interest Rates: Nominal and Real

    An interest rate is the cost of borrowing money, expressed as a percentage of the loan amount. Interest rates are the primary yardstick for measuring how much return lenders will get. However, ...
  5. Investing

    What Does Nominal Mean?

    Nominal refers to an unadjusted value or change in value.
  6. Personal Finance

    How Interest Rates Can Go Negative

    Central banks from Europe to Japan have implemented a negative interest rate policy (NIRP) in order to stimulate economic growth.
  7. Trading

    A Red Flag to the U.S. Equity Market: Rate Hikes

    Discover why the Federal Reserve may raise interest rates in 2016, why that might be necessary and why equity markets might not like it.
  8. Insights

    How Interest Rates Affect The U.S. Markets

    Interest rates can have both positive and negative effects on U.S. stocks, bonds and inflation.
  9. Insights

    The International Fisher Effect: An Introduction

    The Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
  10. Insights

    The Taylor Rule: Calculating Monetary Policy

    The Taylor Rule suggests how the central bank should change interest rates to account for inflation and other economic conditions.
RELATED FAQS
  1. What is the difference between real and nominal interest rates?

    Learn what nominal interest rates and real interest rates are, how real interest rate takes into account the inflation rate, ... Read Answer >>
  2. Can real interest rates be negative?

    Discover the circumstances that can cause real interest rates to be negative and learn how to calculate the values of real ... Read Answer >>
  3. How does the Fisher effect illustrate returns on bonds?

    Learn how the Fisher effect shows the impact of expected future increases in inflation on the prices of bonds and their interest ... Read Answer >>
  4. How do nominal interest rates in finance differ from the nominal rate of interest ...

    Read about the subtle difference between a financial instrument's nominal interest rate of return and the general nominal ... Read Answer >>
  5. How were nominal interest rates in the economy set before the Federal Reserve?

    Learn more about how nominal interest rates are determined, how the Federal Reserve targets them, and how they acted prior ... Read Answer >>
  6. How does inflation affect fixed-income investments?

    Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ... Read Answer >>
Hot Definitions
  1. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  2. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  3. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  4. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  5. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  6. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
Trading Center