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. Nominal

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

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

    A type of fixed-income investment that guarantees a real rate ...
  5. Nominal Yield

    The coupon rate on a bond. The nominal yield is the interest ...
  6. Real Value

    Nominal value adjusted for inflation. Real value is obtained ...
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. Investing

    Understanding the Fisher Effect

    The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.
  3. 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, ...
  4. Trading

    How Inflation Policy Affects You

    The Fed estimates a long-term goal of 2% inflation for the near future. Learn how that'll impact you.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. Insights

    The Taylor Rule: An Economic Model For Monetary Policy

    This interest rate forecasting model has helped central banks around the world adjust their rates to balance out inflation.
  10. Investing

    What is a Nominal Value?

    The nominal value of a security, such as a stock or bond, remains fixed for the duration of its life.
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 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 >>
  6. What does the Fisher Effect say about nominal interest rates?

    Read about what economists call the Fisher effect, which states that real interest rates are equal to nominal rates minus ... Read Answer >>
Hot Definitions
  1. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  2. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that eventually eliminated tariffs to encourage economic activity between the United ...
  3. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  4. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
  5. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
  6. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
Trading Center