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.