Nominal interest rate vs real rate: an overview
Interest rates represent the cost of borrowing and the return on saving and investing. They are expressed as a percentage of the total amount of a loan or investment. It can be the total return lenders receive when they provide loans or the return people earn when they save and invest.
Interest rates can be expressed in nominal or real terms. A nominal interest rate is equal to the real interest rate plus a projected rate of inflation. A real interest rate reflects the real cost of funds to the borrower and the real return to the lender or an investor.
Key points to remember
- Interest rates represent the cost of borrowing or the return on savings, expressed as a percentage of the total amount of a loan or investment.
- A nominal interest rate refers to the total of the real interest rate plus a projected rate of inflation.
- A real interest rate provides the real return on a loan (to the lender) and a bond (to the investor).
- To calculate the real interest rate, subtract the actual or expected rate of inflation from the nominal interest rate.
- Nominal interest rates can indicate current market and economic conditions while real interest rates represent the purchasing power of investors.
Nominal interest rate
The nominal interest rate is the rate announced by banks, debt securities issuers and investment firms for loans and various investments. This is the reported rate of interest paid or earned to the lender or investor. So if you as a borrower get a $100 loan at 6% interest, you can expect to pay $6 in interest. The rate has been increased to take inflation into account.
Nominal interest rate = Real interest rate + Projected inflation rate
Short-term nominal interest rates are set by central banks. These rates serve as the basis for other interest rates charged by banks and other institutions, for example, consumer loans and credit card balances. Central banks may decide to keep nominal rates low in order to stimulate economic activity.
Low nominal rates encourage consumers to take on more debt and increase their spending. Such was the case after the Great Recession when the US Federal Reserve lowered the federal funds rate to a range of 0% to 0.25%. The rate remained within this range between December 2008 and December 2015.
It is important to understand that to get the actual short-term federal funds rate, one would have to subtract the inflation rate from the nominal rate. For example, the Personal Consumption Expenditure (PCE) rate, which is the rate the Fed focuses on to measure inflation, could be subtracted.
Typically, this will result in a lower real federal funds rate that is more stimulus to the economy than the published nominal rate that the media and government typically refer to.
The nominal term can also refer to the advertised or declared interest rate on a loan, without taking into account any fees or compound interest.
Inflation refers to the rise in prices of goods and services. As the rate of inflation increases (meaning these goods and services become more expensive), the amount we can buy with our money decreases. We then speak of a loss of purchasing power. Continued inflation can erode not only what we can afford to buy, but also our savings and investments. The loss of purchasing power and income can be problematic for consumers and businesses. This is why a projected inflation rate is added to real interest rates for a nominal interest rate that will pay a lender or investor a rate high enough to offset what inflation will eat away at their real return. .
Real interest rates
A real interest rate is the interest rate that is added to the projected rate of inflation to provide the nominal interest rate. Simply put, this interest rate provides insight into the actual return received by a lender or investor after taking into account a rate of 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 the yield of a Treasury bill and the yield of a Treasury inflation-protected security (TIPS) of the same maturity, which estimates inflation expectations in the economy.
You can also calculate the actual interest rate associated with a credit or investment product. To do this, you first need the nominal rate and an actual or estimated inflation rate:
Real interest rate = Nominal interest rate – Projected inflation rate
The formula above is derived from the Fisher effect. Developed by economist Irving Fisher in the 1930s, it is the theory that interest rates rise and fall in direct relation to changes in inflation rates. It suggests that the real interest rate – or the return received by lenders and borrowers – declines as inflation rises, until nominal interest rates rise in line with inflation.
Suppose a bank lends $200,000 to a home buyer at a nominal rate of 3%. Suppose the inflation rate is 2%. The actual interest rate paid by the borrower is 1%. The real interest rate the bank receives is 1%. Although this borrowing rate may be suitable for the buyer, it may not be profitable for the lender.
Investors, lenders, and borrowers may invest, borrow, or make loans at a nominal rate of interest, but their primary concern should be effective interest rates. These are the actual rates of return received when the compound interest and fees associated with a product are taken into account. The nominal interest rate does not reflect these effects. For example, an investment with a nominal interest rate of 8.1% may have a lower effective (real) interest rate if it compounds interest less often than a similar investment paying 8%.
It’s a good idea to ask for the effective annual interest rate on any financial product before buying it so you know what you will actually pay or receive. The effective annual interest rate can also be used to compare products like for like.
|Nominal interest rate||Real interest rate|
|Equals real interest rate plus inflation||Equals nominal interest rate minus inflation|
|Rate announced by financial institutions for loans, savings accounts and investments||Shows the actual cost of borrowing and actual investment returns|
|Is higher than the real interest rate to provide a profit to lenders and investors, taking into account the rate of inflation||Can be negative if inflation is above nominal rates|
While some of the key differences between nominal and real interest rates are highlighted above, we’ve noted other considerations about each below.
Cost of Money vs Purchasing Power
One of the key distinctions between nominal and real interest rates is how much you pay to borrow versus purchasing power.
Real interest rates give savers, investors and borrowers insight into their purchasing power by allowing them to compare the real interest rate to the rate of inflation. They give an idea of what they will earn from an investment or savings account. They can then compare this real interest rate to the rate of inflation. When inflation is high, it decreases an investor’s purchasing power. In times of low inflation, purchasing power increases.
Nominal rates, on the other hand, are indicative of the current mood or conditions of the market, the state of the economy, and the total price of silver. When the economy is healthy, nominal rates tend to be higher than during tough economic times. When they are higher, people pay more for the money they borrow.
Remember that nominal interest rates are equal to real interest rates plus the expected rate of inflation. After all, banks want to make a profit. As such, they must take this into account when announcing their prices. Thus, lenders who want to earn 6% interest when the inflation rate is 2% (and expected to rise) can factor in their nominal rates for a higher level of inflation.
Real interest rates can end up in negative territory when a substantial rate of inflation is subtracted from a nominal rate that is not so high. So if you have a savings account that pays a nominal interest rate of 1% but inflation hovers around 2%, your real rate of return is -1%.
Nominal rates cannot be expressed as a negative number. People who save money in an account with a negative interest rate would actually pay the bank to hold their money. Similarly, a bank that charges its customers a negative interest rate would have to pay its borrowers on loans.
How do you calculate real and nominal interest rates?
To calculate the real interest rate, you need to know both the nominal interest rate and the inflation rate. The real interest rate formula is the nominal interest rate minus the inflation rate. To calculate the nominal rate, add the real interest rate and the inflation rate.
Is the bank interest rate on a loan nominal or real?
The interest rates announced by the banks on any product are nominal interest rates. These are actual interest rates with an estimated inflation rate added to ensure the bank can make a profit on its transaction.
What happens when real interest rates rise?
Higher real interest rates can increase borrowing costs. This can cause people to cut back on spending and borrowing. This, in turn, can slow down economic activity. Of course, higher real interest rates can also improve the returns people can get on their investments.
Are nominal interest rates higher than real interest rates?
Nominal interest rates are generally higher than real interest rates. This is because nominal rates are determined by taking real interest rates and adding a projected rate of inflation. So, unless inflation is 0%, the nominal rate would be higher.
How does inflation affect real interest rates?
According to the Fisher effect, real interest rates fall as inflation rises, until nominal rates also rise. Generally speaking, rising inflation may prompt the Fed to raise short-term nominal rates in an attempt to reverse it. Inflation makes products and services more expensive and thus reduces consumers’ purchasing power, or what they can buy with the same amount of money as prices rise. Inflation also erodes savings and investment returns.
It is useful to understand the difference between nominal and real interest rates, as they can inform consumers about their purchasing power and the real costs of borrowing. For example, nominal interest rates indicate what we would be charged for a loan, but the actual interest rate can help us decide whether or not the loan is too expensive for our budgets.
In terms of purchasing power, a positive real interest rate is always good, unless the rate of inflation is higher. The inflation rate reduces what we earn with the real interest rate.