- The real interest rate takes into account the impact of inflation on the cost of borrowing and the return on savings.
- It is calculated by subtracting the inflation rate from the nominal interest rate.
- If inflation levels exceed the nominal rate on a savings account, the dollars you invest will lose purchasing power.
Interest is the amount of money a lender charges a borrower or a saver earns on deposits and investments. But there are several types of interest rates, each measuring costs and returns differently, including the real interest rate.
What is a real interest rate?
The real interest rate indicates the real cost of borrowing or the return on savings after taking into account the impact of inflation. This gives consumers a more complete picture of how interest rates will affect their long-term finances.
As the impact of inflation can be significant, real interest rates provide a useful benchmark for borrowers and savers. Higher real interest rates are generally good for savers but bad for borrowers. On the other hand, lower real interest rates tend to benefit borrowers and hurt savers.
Why it’s important to understand real interest rates
Real interest rates affect your purchasing power. As a simple example, let’s say you plan to buy a product that costs $103, but you only have $100. You decide to put this money in an account that pays 3% simple interest for one year, so at the end of the year you will have $103. However, inflation was 5%, so at the end of the year the product costs $105. With this price increase, you would not have enough to buy it, because when drawing up the savings plan, you only considered the nominal interest rate and not the real interest rate. The value of your money actually went down during the time you had it in the account.
“If a real interest rate is positive, it implies that you will have more purchasing power in the future if you start saving today,” says Toni Nasr, chartered financial analyst (CFA) at Investing in the website. “On the other hand, if the real interest rate is negative, saving today to buy the same product later will not be possible, because your purchasing power will decrease.”
The possibility of negative real interest rates in an inflationary environment leads buyers to prefer buying goods today rather than waiting to make the purchase. This is commonly referred to as the time preference theory of interest.
You can take advantage of research beyond nominal interest rates to find the actual interest rate when making investing and borrowing decisions. At the very least, it will let you know if a potential opportunity will eventually erode your buying power.
You can calculate the real interest rate by subtracting the inflation rate from the nominal interest rate. Here is the formula:
Real interest rate = nominal interest rate – inflation rate (actual or expected)
The bottom line
Interest rates play a key role in the financial lives of consumers. But with the different ways interest rates are calculated and expressed, it’s easy to get lost in what they’re telling you.
When shopping for a loan or savings account, you will often see nominal interest rates advertised. They reflect to you the amount of interest paid or earned before adjusting for inflation. Real interest rates give a fuller picture because they are adjusted for changes in the purchasing power of money borrowed or deposited.
So when it comes to interest rates, it’s important to remember that what you see isn’t necessarily what you get. Understanding what interest rate you’re considering is key to getting the most out of your money.