Nominal vs Real Interest Rates

The portion of a loan that is charged to the borrower is called an interest rate, and it is often stated as an annual percentage. Lenders utilize interest rates to cover the risk they assume when making loans, and they can also be used to help keep inflation under control.

What is the Nominal Interest Rate?

The interest rate that is offered to you without taking into account the effects of inflation is called the nominal interest rate. It is the rate that is used to determine how much interest you will pay on loan or how much interest you will earn on investments. You will pay 10% interest on the loan’s principle each year, for instance, if you take out a loan with a nominal interest rate of 10%. Your investment will grow by 5% annually if you place it in a savings account with a nominal interest rate of 5%.

The effect of inflation, or the rate at which the general level of prices for goods and services is rising, is not taken into account by the nominal interest rate. The buying power of the money you get from a loan or investment will be lower than the purchasing power of the money you paid out when the inflation rate is higher than the nominal interest rate. When comparing various loans or investments, the nominal interest rate might be helpful. Still, it’s crucial to take the real interest rate—which accounts for the impact of inflation—into account.

What is the Real Interest Rate?

The interest rate that accounts for the impact of inflation is known as the real interest rate. The rate determines how much money’s purchasing power has changed over time. The nominal interest rate is subtracted from the inflation rate to determine the real interest rate. For instance, the real interest rate would be 2% if you took out a loan with a nominal interest rate of 5% and the inflation rate was 3%. This indicates that over time, after considering the impacts of inflation, the purchasing power of the money you get from the loan will rise by 2%. 

Because it displays the actual cost of borrowing money or the actual return on an investment, the real interest rate is significant. The purchasing value of the money you receive from the loan or investment will be higher than the purchasing power of the money you paid out when the real interest rate is positive. The purchasing power of the money you receive will be lower than the purchasing power of the money you pay out when the real interest rate is negative. When making financial decisions, it is crucial to take the real interest rate into account because it impacts the loan or investment’s long-term worth.

Real Interest Rate = Nominal Interest Rate – Rate of Inflation

Distinction Between Nominal and Real Interest Rates

The interest rate that is specified in a loan or deposit agreement is known as the nominal interest rate. It is the interest rate quoted to both borrowers and lenders and is used to determine how much interest will be paid on loan or earned on a deposit. The nominal interest rate is presented as a percentage of the loan or deposit’s principal. The nominal interest rate is adjusted for inflation to get the real interest rate. It accounts for changes in the purchasing power of money over time and indicates the actual cost of borrowing or the genuine return on a deposit. Some significant differences between nominal and real interest rates are listed below:

• Real interest rates are determined based on the nominal interest rate and the inflation rate, whereas nominal interest rates are indicated in a loan or deposit agreement.
• Real interest rates indicate the genuine cost of borrowing or the actual return on a deposit. In contrast, nominal interest rates are used to compute interest payments on loans or the interest collected on deposits.
• Real interest rates account for inflation, but nominal interest rates do not consider how inflation affects the purchasing power of money.
• When inflation rises, nominal interest rates are frequently higher than real interest rates. In contrast, when inflation is negative, nominal interest rates are frequently lower than real interest rates.
• Purchasing power is related to the nominal and real interest rates because it is affected by inflation, which can reduce the value of money over time. When the inflation rate is higher than the nominal interest rate, the real interest rate will be negative, which means that the purchasing power of the money you receive from the loan or investment will be less than the purchasing power of the money you paid out. When the inflation rate is lower than the nominal interest rate, the real interest rate will be positive, which means that the purchasing power of the money you receive will be greater than the purchasing power of the money you paid out.

How do you Calculate Nominal and Real Interest Rates?

You would need to know the nominal interest rate and the inflation rate to compute the real interest rate. The nominal interest rate is subtracted from the inflation rate to determine the real interest rate.

The real interest rate, for instance, would be 2% if you had a loan with a nominal interest rate of 5% and a 3% inflation rate. This can be calculated as follows:

The real interest rate is calculated as the interest rate minus inflation.

Real Interest Rate = 5%-3%
Therefore, the real interest rate is 2%.

The real interest rate and inflation rate must be known to determine the nominal interest rate. The real interest rate is multiplied by the inflation rate to arrive at the nominal interest rate.

Is a Bank’s Loan Interest Rate Nominal or Real?

A nominal interest rate is frequently used when quoting a bank’s interest rate on a loan. The interest rate that is offered to you without taking into account the effects of inflation is called the nominal interest rate. The rate is used to figure out how much interest you’ll pay on a loan. The nominal interest rate can be either constant or variable and is stated as an annual percentage. In contrast to variable interest rates, which can change over time, fixed interest rates guarantee that the interest rate will not change over the loan’s tenure. 

It is crucial to remember that the nominal interest rate, which measures how quickly prices for goods and services are rising, does not account for inflation. The real interest rate, which accounts for the impact of inflation, is negative when the nominal interest rate is higher than the inflation rate, which indicates that the buying power of the money you receive from the loan will be lower than the purchasing power of the money you paid out.

For instance, the real interest rate would be negative 1% if you took out a loan with a nominal interest rate of 5% and the inflation rate was 6%. As a result, the money you borrow will have a lower purchasing power than the amount you pay back.

How does Inflation Affect the Real Interest Rate?

Inflation can affect real interest rates in the following ways:

• When the inflation rate is higher than the nominal interest rate (the interest rate quoted before accounting for the effects of inflation), the real interest rate (the interest rate that considers the impact of inflation) will be negative. This means that the purchasing power of the money you receive from the loan or investment will be less than the purchasing power of the money you paid out.
• The real interest rate will be positive if the inflation rate is lower than the nominal interest rate. This indicates that the amount of money you borrow or invest will have a higher purchasing power than the amount you pay out.
• The real interest rate will be zero if inflation is at the same rate as the nominal interest rate. This indicates that the buying power of the money you get as a result of the loan or investment will equal the purchasing power of the money you disbursed.

Cost of Money vs. Purchasing Power

The cost of money is the sum of money that a person or company must pay to borrow money, whereas purchasing power is the number of goods or services that a certain sum of money may buy. The amount of money that must be paid back over a predetermined period of time as interest is how the cost of money is typically stated. The cost of borrowing money increases as the interest rate rises.

Purchasing power, on the other hand, is a measure of how much a given amount of money can buy in terms of goods or services. Several factors, including the level of inflation in the economy, the availability of goods and services, and the relative strength of different, influence it.

In general, when the cost of money is high, purchasing power is low, and the opposite is true when the cost of money is low. This is because when money is expensive, people and businesses have less disposable income to spend on products and services, which can reduce demand and drive down the cost of those goods and services. On the other hand, when the cost of money is low, people and businesses have more money than they may spend. This can lead to an increase in demand for goods and services as well as an increase in their cost.

Negative Rates

Negative nominal interest rates refer to a situation where the stated or advertised interest rate on a loan or investment is less than zero. This means that the borrower or investor is effectively being paid to borrow or invest rather than paying interest to the lender. Negative nominal interest rates are typically used as a monetary policy tool to encourage borrowing and stimulate economic activity.

A negative real interest rate occurs when the real return on investment is less than zero, even if the nominal interest rate is positive. This can happen when the inflation rate is higher than the nominal interest rate, resulting in a decline in the purchasing power of the investment.

In summary, negative nominal interest rates refer to a situation where the advertised interest rate on a loan or investment is less than zero. In contrast, negative real interest rates refer to a situation in which the actual return on investment, after accounting for inflation, is less than zero.

Wrapping Up

The distinction between nominal and real interest rates is crucial because it affects both borrowers and lenders in different ways. The nominal interest rate, used to compute interest payments on loans and interest received on deposits, is the interest rate specified in a loan or deposit agreement. The real interest rate, on the other hand, takes into account changes in the buying power of money over time and indicates the genuine cost of borrowing or the true return on a deposit. When making financial decisions, it’s crucial to consider both nominal and real interest rates because they can have differing effects on borrowing costs and deposit returns. 

FAQ on Nominal and Real Interest Rates

Q1. What is the difference between Nominal and Real Interest Rates?

Ans. Nominal interest rates are the stated interest rates in a loan or deposit agreement, while real interest rates are the nominal interest rates adjusted for inflation. Real interest rates reflect the true cost of borrowing or the true return on a deposit, taking into account the changes in the purchasing power of money over time.

Q2. Why is it Important to consider both Nominal and Real Interest Rates?

Ans. It is essential to consider both nominal and real interest rates when making financial decisions because they can have different impacts on the cost of borrowing and the return on a deposit. The nominal interest rate determines the interest payments on a loan or the interest earned on a deposit. In contrast, the real interest rate reflects the true cost of borrowing or the true return on a deposit, considering the impact of inflation.

Q3. Can Nominal Interest Rates be Higher or Lower than Real Interest Rates?

Ans. Yes, nominal interest rates can be either higher or lower than real interest rates depending on the inflation rate. When the inflation rate is positive, nominal interest rates are often higher than real interest rates. Conversely, when the inflation rate is negative, nominal interest rates are often lower than real interest rates.

Q4. How is the Real Interest Rate Calculated?

Ans. The real interest rate is calculated using the following formula: Real interest rate = Nominal interest rate – Inflation rate