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 reflects the rate of time-preference for current goods over future goods. The real interest rate of an investment is calculated as the difference between the nominal interest rate and the inflation rate:
Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)
- The real interest rate adjusts the observed market interest rate for the effects of inflation.
- The real interest rate reflects the purchasing power value of the interest paid on an investment or loan and represents the rate of time-preference of the borrower and lender.
- Because inflation rates are not constant, prospective real interest rates must rely on estimates of expected future inflation over the time to maturity of a loan or investment.
Interest Rates: Nominal and Real
Understanding Real Interest Rate
While the nominal interest rate is the interest rate actually paid on a loan or investment, the real interest rate is a reflection of the change in purchasing power derived from an investment or given up by the borrower. The nominal interest rate is generally the one advertised by the institution backing the loan or investment. Adjusting the nominal interest rate to compensate for the effects of inflation helps to identify the shift in purchasing power of a given level of capital over time.
According to the time-preference theory of interest, the real interest rate reflects the degree to which an individual prefers current goods over future goods. A borrower who is eager to enjoy the present use of funds shows a stronger time-preference for current goods over future goods and is willing to pay a higher interest rate for loaned funds. Similarly a lender who strongly prefers to put off consumption to the future shows a lower time-preference and will be willing to loan funds at a lower rate. Adjusting for inflation can help reveal the rate of time-preference among market participants.
Expected Rate of Inflation
The anticipated rate of inflation is reported by the U.S. Federal Reserve to Congress on a regular basis 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.