Nominal vs. Real Interest Rate: Key Differences

Writer:

Ana-Maria Sanders

Editor:

Jim Hughes

Reviewer:

Sophia Rodriguez

The difference between nominal and real interest rates becomes especially critical during high inflation. Sudden inflation well illustrates this, as investment returns are markedly affected, changing their worth over time. To make sound financial decisions, investors must grasp the key differences between nominal and real interest rates and how economic conditions influence these rates. 

What Is the Nominal Interest Rate?

The nominal interest rate is the interest rate of a financial product, such as a loan or bond, without considering inflation. It is a simple measure that provides the return on investment or the cost of borrowing, but it does not account for the changing value of money over time. The formula explains the nominal interest rate:

Nominal Interest Rate = Real Interest Rate + Inflation Rate

This rate is often used to compare loans or savings accounts because it offers a simple baseline for evaluation. For example, if you invested $2,000 in a bond earning a nominal interest rate of 5% per annum, at the end of the year, you would have earned $100, bringing your total to $2,100.

Functional as it may be, the nominal interest rate has shortcomings. It does not reflect the actual cost of borrowing or the real value of returns, as it fails to account for the eroding effect of inflation. This can be confusing, particularly during periods of high inflation. The APR, or real rate of interest, is also necessary. It would give a broader view of financial commitments or returns and, more accurately, the real economic consequence of an investment or loan.

What Is the Real Interest Rate?

The real interest rate is the real return on investment or the actual cost of borrowing when the inflation rate is considered. It reflects changes in purchasing power, offering a clearer picture of the actual economic impact of interest rates. The actual interest rate formula is:

Real Interest Rate = Nominal Interest Rate - Inflation Rate

For instance, suppose you invest $2,000 in a bond with a nominal interest rate of 5% annually. At the end of the year, you would have earned $100 in nominal terms, making your total $2,100. However, if the inflation rate during that period is 4%, then the real interest rate would be:

Real Interest Rate = 5% - 4% = 1%

This means your purchasing power goes up only by 1% since the cost of goods has risen through inflation, eroding some value from the return you obtained. Your earnings were $100 in nominal interest, while their actual or real value is lowered because they can purchase less than at the year's opening.

Understanding the real interest rate is necessary for assessing the actual profitability of investments or the true cost of loans, considering how inflation impacts financial decisions.

The Key Differences Between Nominal and Real Interest Rates?

Let’s discuss the differences between nominal vs accurate interest rates. Nominal and real interest rates reveal the sum a person will earn on an investment. Nonetheless, they have significant differences. The main difference is that the nominal interest remains stable for the investment period. Conversely, the real interest rate fluctuates based on the inflation rate.

Moreover, inflation can reduce the value of money. Therefore, calculating the return rate in real value rather than nominal value offers a clearer picture of the investment's success and the actual return after adjusting for inflation. Consequently, investors can determine whether they should take more risks or exit the market.

Below is a comparison table between nominal vs real interest rates.

When to Use Nominal Interest Rates

Here is a guide for when to use nominal interest rates:

Comparing Financial Products

Nominal rates are usually advertised when comparing loans, credit card interest rates, or savings accounts. They provide a starting point for comparison.

Short-Term Decisions

The nominal rate is often helpful for decisions on which inflation has little effect (e.g., short-term loans or investments). 

Budgeting and Planning

Nominal rates indicate the amounts of fixed payment obligations. For example, mortgage or automobile loan rates stay constant throughout the term.

When to Use Real Interest Rates

Real interest rates are crucial in situations where inflation plays an important role:

Evaluating Investment Returns

Real rates help to determine the actual growth of purchasing power from investments, especially for long-term financial planning.

Analyzing the Cost of Borrowing

Real rates give the actual cost of a loan when the inflation rate is high, thus enabling the borrower to know how much he is paying in real terms.

Economic Insights

Economists and policymakers use accurate rates to analyze economic health and make decisions based on inflation's impact on growth and stability.

High Inflationary Periods

In periods of high inflation, actual rates are crucial regarding whether an investment or loan will be genuinely advantageous.

The nominal interest rate is a tool for determining the return on investment. It is a percentage of the return on investment, whereas the real interest rate considers inflation to measure the actual value of an asset. Therefore, investors should know the difference between nominal and real interest rates. The nominal rate will reveal the state of the market, whereas the real rate will disclose the actual returns from the market.

FAQ

What Is The Difference Between Nominal And Real In Finance?

The nominal interest rate is the stated rate on financial products without considering inflation. In contrast, the real interest rate adjusts for inflation to reflect the changes in purchasing power or returns.

Do Banks Charge Nominal Or Real Interest Rates?

Banks typically charge the nominal interest rate on loans and display it on savings accounts. However, the real interest rate, which accounts for inflation, determines the actual cost of borrowing or the real value of returns.

Which Is More Important, Nominal Or Real Rates?

Both rates are essential but serve different purposes. Nominal rates are helpful for comparison and simplicity, while actual rates provide a more accurate measure of financial impact by reflecting the actual purchasing power after inflation.

How Does Inflation Affect The Nominal Interest Rate?

Inflation indirectly influences nominal rates. Higher inflation generally leads to higher nominal interest rates as lenders adjust to compensate for the declining value of money, ensuring they maintain profitability.

What Is A Good Real Interest Rate For Investments?

A positive real interest rate is desirable, as it indicates your investment is outpacing inflation and increasing purchasing power. The "good" rate depends on economic conditions and investment goals but typically ranges between 2% and 4%.