Nominal vs. Real Interest Rate:An Overview
Interest rates represent the cost of borrowing and the return on savings and investing. They're expressed as a percentage of the total amount of a loan or investment. They can be the total return lenders receive when they offer 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 equals the real interest rateplus a projected rate ofinflation. A real interest rate reflects the truecost of fundsto the borrower and the real yield to the lender or to an investor.
Key Takeaways
- Interest rates represent the cost of borrowing or the return on saving, 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 actual return on a loan (to the lender) and on 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 that is advertised by banks, debt issuers, and investment firms for loans and various investments. It is the stated interest rate paid or earned to the lender or by investor. So, if as a borrower, you get a loan of $100 at a rate of 6%, you can expect to pay $6 in interest. The rate has been marked up to take account of inflation.
Nominal Interest Rate = Real Interest Rate + Projected Rate of 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 on, e.g., loans to consumers and credit card balances. 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 the federal funds rate to a range of 0% to 0.25%. The rate remained in this range between December 2008 and December 2015.
It's important to understand that to obtain the real short-term federal funds rate, one would subtract the inflation rate from the nominal rate. For example, the personal consumption expenditure (PCE) rate, which is the rate that the Fed focuses on to gauge inflation, could be subtracted.
Typically, that will result in an actual lower fed funds rate that's more stimulative for the economy than is the published, nominal rate usually referred to by media and the government.
The term nominalcan also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.
Inflation refers to the rise in prices for goods and services. As the rate of inflation grows (meaning those goods and services get more expensive), the amount we can purchase with our money decreases. This is referred to as a loss of purchasing power. Ongoing inflation can erode not just what we can afford to buy, but our savings and investments, as well. Loss of purchasing power and earnings can be problematic for consumers and businesses. That's 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 compensate for what inflation will eat away from their actual return.
Real Interest Rate
A real interest rate is the interest rate that is added to the projected rate of inflation to provide the nominal interest rate. Put simply, this interest rate provides insight into the actual return received by a lender or investor after a rate of inflation is acknowledged. 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 bondyield 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. To do so, you first need the nominal rate and an actual or estimated rate of inflation:
Real Interest Rate = Nominal Interest Rate - Projected Rate of Inflation
The formula above is derived from the Fisher Effect. Developed by economist Irving Fisher in the 1930s, it's the theory that interest rates rise and fall in direct relationship to changes in inflation rates. It suggests that the real interest rate—or the return received by lenders and borrowers—drops as inflation rises, until nominal interest rates rise in conjunction with inflation.
Suppose a bank lends $200,000 to a homebuyer at a nominal rate of 3%. Assume the inflation rate is 2%. The real interest rate that the borrower pays is 1%. The real interest rate that the bank receives is 1%. While that rate of borrowing may be fine for the homebuyer, it may not be profitable for the lender.
It's a good idea to ask for the effective annual interest rate on any financial product before purchasing it so you know what you'll actually pay or receive. The effective annual interest rate can also be used to compare products in an apples-to-apples way.
Key Differences
| Nominal Interest Rate | Real Interest Rate |
|---|---|
| Equals real interest rate plus inflation | Equals nominal interest rate less inflation |
| Rate advertised by financial institutions for loans, savings accounts, and investments | Shows the real cost of borrowing and real returns from investing |
| Is higher than the real interest rate to provide profit to lenders and investors, given inflation rate | Can be negative if inflation is higher than nominal rates |
| Often used more by borrowers and lenders | Often used more by investors and analysts |
How It Impacts Investors
Investors must be mindful of nominal and real interest rates, as the yield they earn on their investment may be substantially different on which one they earn. Consider a simple example where an investor is earning a 3% nominal rate during a period of 5% inflation. Though the investor can claim they are generating a positive return (which they technically are), the amount they are earning is less than the prevailing increase in costs.
This concept also impacts specific investments. For example, holding TIPS when the Treasury yield curve is less than the expected inflation rate means that investors are actually paying money to hold the TIPS investment instead of earning interest.
To a lesser degree, the same can be said regarding inflation-tied bonds such as Series I bonds issues by the U.S. government. These bonds are tied to an average rate of inflation over a period of time. Though investors could boast they were earning upwards of 9% during the inflation spike in 2022, the nominal rate of 9% was quickly reduced to less than a 1% real rate of return when considering inflation.
Other Users of Real and Nominal Rates
In addition to having impacts on investors, real and nominal rates and used by a variety of users. These users may include but aren't limited to:
- Borrowers and Lenders. When individuals, businesses, or governments borrow or lend money, they use nominal rates to determine the interest payments. Borrowers use this nominal interest rate to calculate the total amount they need to repay, while lenders use it to determine their income from interest.
- Monetary Policy Makers. Central banks set nominal interest rates as a tool to influence the overall economy. By adjusting these rates, central banks can encourage or discourage borrowing and spending, which in turn affects inflation and economic growth.
- Financial Institutions. Banks and financial institutions base the terms of various financial products, such as savings accounts, certificates of deposit, and loans, on nominal rates.
- Economic Analysts. Economists and financial analysts use real rates to understand economic trends accurately. Real interest rates help to evaluate the health of an economy, the attractiveness of investments, and the potential impact of policy changes as economists may want to track changes without pricing implications.
- Businesses and Governments. Businesses and governments use real rates to evaluate the feasibility of projects. This approach ensures that investment decisions are based on the actual return on investment in real terms, accounting for inflation's impact.
- International Firms. Real rates are essential when comparing economic conditions between countries. Since inflation rates vary, comparing nominal rates directly could be misleading. Real rates provide a standardized metric for comparing economic performance.
Real vs. Nominal: Other Applications
The relationship between real and nominal interest rates can be expounded to other economic concepts. For example, economists may analyze the change in real vs. nominal prices of goods.
Through their analysis, economists often assign a baseline constant to real values. For example, an economist may analyze real interest rates over time by seeing a given interest rate in the year 2000. Then, it can compare this baseline to every year since. Since the analyst is observing real rates and not nominal rates, fluctuations of the rate are absent any impacts of inflation. This same concept can be applied to prices (i.e. the cost of a banana in the year 2000 vs. every year since). The same analysis can be performed using nominal rates which introduces a material variable.
The same concept that distinguishes real and nominal rates also distinguishes gross domestic product and nominal gross domestic product. Nominal GDP represents what actual prices were at a given time, while GDP reflects and adjusts these prices to create a more comparative baseline to monitor true, non-inflationary growth.
Special Considerations
While some of some of the main differences between nominal and real interest rates are highlighted above, there are some other considerations that we've noted 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 inflation rate. They provide an idea of how much they'll earn from an investment or savings account. They can then compare that real interest rate to the inflation rate. When inflation is high, it decreases an investor's purchasing power. 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, the state of the economy, and the total price of money. When the economy is healthy, nominal rates tend to be higher than in times of economic distress. When they're higher, people pay more for the money they borrow.
Remember that nominal interest rates equal real interest rates plus the expected rate of inflation. After all, banks want to make a profit. 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 2% (and is expected to rise) may factor into their nominal rates a higher level of inflation.
Negative Rates
Real interest rates can end up in negative territory when a substantial inflation rate is subtracted from a nominal rate that isn't that high. 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%.
Nominal rates 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 Rates?
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.
Is a Bank Interest Rate on a Loan Nominal or Real?
Interest rates advertised by banks on any product are nominal interest rates. They are real interest rates with some estimated rate of inflation added in to ensure that the bank can make a profit on its transaction.
What Happens When Real Interest Rates Increase?
Higher real interest rates can increase borrowing costs. This can cause people to curb spending and borrowing. This, in turn, can slow economic activity. Of course, higher real interest rates can also improve the returns people may earn on their investments.
Are Nominal Interest Rates Higher Than Real Interest Rates?
Nominal interest rates are usually higher than real interest rates. That's because nominal rates are determined by taking real interest rates and adding a projected rate of inflation to them. 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 drop as inflation rises, until nominal rates also rise. Generally speaking, rising inflation may prompt the Fed to raise nominal short-term rates to try to reverse it. Inflation makes products and services more expensive and thereby reduces consumer purchasing power, or how much they can buy with the same amount of money as prices go up. Inflation also erodes the returns on savings and investments.
The Bottom Line
It's useful to understand the difference between nominal and real interest rates because they can inform consumers about their purchasing power and true costs of borrowing. For example, nominal interest rates indicate what we'd be charged for a loan, but the real interest rate can help us decide whether or not the loan is too costly for our budgets.
As far as purchasing power goes, a real interest rate that's positive is always good, unless the inflation rate is greater. The inflation rate reduces what we earn with the real interest rate.
Article Sources
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