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Real vs. Nominal Interest Rates: What's The Difference?

This document discusses the difference between real and nominal interest rates. A real interest rate takes inflation into account, while a nominal rate does not. To calculate the real rate, you subtract the inflation rate from the nominal rate. The real rate shows the purchasing power change for lenders and borrowers after accounting for inflation. Nominal rates are quoted without considering inflation effects and are set by central banks to influence economic activity.

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187 views5 pages

Real vs. Nominal Interest Rates: What's The Difference?

This document discusses the difference between real and nominal interest rates. A real interest rate takes inflation into account, while a nominal rate does not. To calculate the real rate, you subtract the inflation rate from the nominal rate. The real rate shows the purchasing power change for lenders and borrowers after accounting for inflation. Nominal rates are quoted without considering inflation effects and are set by central banks to influence economic activity.

Uploaded by

Samantha Estilong
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© © All Rights Reserved
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MONETARY POLICY    INTEREST RATES

Real vs. Nominal Interest Rates: What's the Difference?


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By STEVEN NICKOLAS

 Updated Dec 18, 2019

TABLE OF CONTENTS

EXPAND

 Overview

 Real Interest Rates

 Nominal Interest Rates

Real vs. Nominal Interest Rates: An Overview


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. A nominal interest rate refers to the interest rate before taking inflation into
account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking
into account any fees or compounding of interest.

KEY TAKEAWAYS

 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
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.

 
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 returnby 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 refers to the interest rate before taking 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% to 0.25%. The rate remained in this range between Dec. 2008 and Dec. 2015.1

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ACCOUNTING
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Interest Rate vs. APR: What's the Difference?

FIXED INCOME TRADING STRATEGY & EDUCATION


How Does Inflation Affect Fixed-Income Investments?

FEDERAL RESERVE
How Interest Rates Affect the U.S. Markets

FEDERAL RESERVE
Interest Rates Explained: Nominal, Real, Effective

Related Terms
Nominal Interest Rate Definition

The nominal interest rate is the interest rate before taking inflation into account, in contrast to real
interest rates and effective interest rates. 
more

What Does Nominal Mean and How Does it Compare to Real Rates

Nominal is a common financial term with several different contexts, referring to something small, an
unadjusted rate, or the face value of an asset.

 more

Determining Your Real Rate of Return

Real rate of return adjusts the profit figure from an investment to take into account the effects of
inflation.

more

After-Tax Real Rate of Return

The after-tax real rate of return is defined as the actual profit or loss of an investment after accounting
for inflation and taxes.

 more

Real Interest Rate Definition

A real interest rate is one that has been adjusted for inflation, reflecting the real cost of funds to the
borrower and the real yield to the lender.

 more

What the Effective Annual Interest Rate Tells Us

The effective annual interest rate is the real return on an investment, accounting for the effect of
compounding over a given period of time.

 more

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