Real vs. Nominal Interest Rates: An Overview
A real interest rate is one that is adjusted to remove the effects of inflation, reflecting the real cost of funds to the borrower and the real yield to the lender or investor. A nominal interest rate, on the other hand, refers to an interest rate that does not factor out inflation. Therefore, it is taken before inflation is taken into account.
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.
To calculate the real interest rate, you first need the nominal interest rate. The calculation used to find the real interest rate is the nominal interest rate minus the actual or expected inflation rate.
[Important: Real interest rates should be considered predictive when the true rate of inflation is unknown or expected.]
Suppose a bank loans a person $200,000 to purchase a house at a rate of 3%—the nominal interest rate not factoring in inflation. Assume the inflation rate is 2%. The real interest rate the borrower is paying is 1%. The real interest rate the bank is receiving is 1%. That means the purchasing power of the bank only increases by 1%.
The real interest rate gives lenders and investors an idea of the real rate they receive after factoring in inflation. This also gives them a better idea of the rate at which their purchasing power increases or decreases. They can estimate their real rate of return by comparing the difference between a Treasury bond yield and a Treasury Inflation-Protected Securities (TIPS) yield of the same maturity, which estimates inflation expectations in the economy.
Nominal Interest Rates
A nominal interest rate is the interest rate that does not take inflation into account. It is the interest rate quoted on bonds and loans. The nominal interest rate is a simple concept to understand. If you borrow $100 at a 6% interest rate, you can expect to pay $6 in interest without taking inflation into account. The disadvantage of using the nominal interest rate is that it does not adjust for the inflation rate.
Short-term nominal interest rates are set by central banks. These rates are the basis for other interest rates that are charged by banks and other institutions to consumers. Central banks may decide to keep nominal rates at low levels in order to spur economic activity. Low nominal rates encourage consumers to take on more debt and increase their spending. This was the case following the Great Recession when the U.S. Federal Reserve dropped its Fed Funds Rate to a range of 0.00% to 0.25%. The rate remained in this range between December 2008 and December 2015.
- 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 does not factor out inflation and is the interest rate quoted on bonds and loans.
- To calculate the real interest rate, you need to subtract the actual or expected rate of inflation from the nominal interest rate.