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. Interest rates can be expressed in real or nominal terms. A real interest 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 interest rate, on the other hand, refers to the interest rate before taking inflation into account.
- 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 Treasury bond yield and a Treasury Inflation-Protected Securities (TIPS) 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. Developed by economist Irving Fisher, this theory suggests that real interest rates drop when inflation rises. That is until nominal interest rates rise as inflation does.
Suppose a bank lends $200,000 to someone who wants to purchase a house at a rate of 3%. This is 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%.
Investors, lenders, and borrowers are also concerned with effective interest rates. These are rates that take compounding into account.
Nominal Interest Rates
The nominal interest rate is a fairly easy concept to understand. It is the rate that is advertised by banks, debt issuers, and investment providers for bonds, loans, and certain investments. It is the interest rate paid or earned before taking inflation into account. So if you borrow $100 at a rate of 6%, 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 inflation.
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% to 0.25%. The rate remained in this range between December 2008 and December 2015.
The term nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.
While some of some of the main differences between real and nominal interest rates are highlighted above, there are some other considerations that we've noted about each below.
What They Represent
One of the key distinctions between the real and nominal interest rates is the degree of purchasing power versus how much you pay or receive in interest.
Investors can use real interest rates to get insight into their purchasing power. As such, individuals know how much they'll be able to earn (and spend) from an investment or savings account when they deposit their money. When inflation is high, it decreases an investor's purchasing power and during periods of low inflation, purchasing power increases.
Nominal rates, on the other hand, are indicative of the current mood or conditions of the market along with the total price of money. As noted above, these rates are influenced by the interest rates set by the central bank—the Federal Reserve in the United States. When things are going well, these rates tend to be higher and end up dropping during times of economic distress.
Keep in mind, though, that nominal interest rates can be advertised using an expected rate of inflation. After all, banks want to earn money. As such, they must take it into account when they advertise their rates. So lenders that want to earn 6% interest when the inflation rate is sitting at 2% (and is expected to rise) must factor that in when deciding and publicizing their interest rates on credit products.
Because real interest rates factor in inflation. they can end up in negative territory. This is common when the rate of inflation is higher than the nominal rate. So if you have a savings account that pays a nominal interest rate of 1% but inflation is hovering around 2%, your actual rate of return is -1%.
This is in contrast to nominal rates, which cannot be expressed as a negative figure. People who save money in an account with a negative interest rate would actually be paying the bank to hold their money. Similarly, a bank that charges customers a negative interest rate would have to pay their borrowers on loans.
How Do You Calculate the Real and Nominal Interest Rate?
In order to calculate the real interest rate, you must know both the nominal interest and inflation rates. The formula for the real interest rate is the nominal interest rate minus the inflation rate. To calculate the nominal rate, add the real interest rate and the inflation rate.
Are Nominal Interest Rates Higher Than Real Interest Rates?
Nominal interest rates are usually higher than real interest rates. That's because real interest rates take inflation into account when they are expressed. In order to figure out the real rate of interest, you must subtract the rate of inflation from the nominal interest rate. This changes if nominal interest rates rise at the same time as inflation does.
How Does Inflation Affect Real Interest Rates?
Real interest rates are rates that already have inflation factored into their equation. They are nominal rates minus the rate of inflation. This rate gives the real rate of a loan or bond and shows just how far a dollar will go for investors.