Nominal vs. Real Interest Rates: 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 rate plus a projected rate of inflation. A real interest rate reflects the true cost of funds to the borrower and the real yield to the lender or to an investor.
- 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 Rates
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 nominal can 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 Rates
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 bond yield 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.
Investors, lenders, and borrowers may invest, borrow, or make loans at a nominal interest rate, but they should be predominantly concerned with effective interest rates. These are the real rates of return received when compounding interest and fees associated with a product are taken into account. The nominal interest rate does not reflect these effects. For example, an investment with a nominal interest rate of 8.1% may have a lower effective (real) interest rate if it compounds interest less often than a similar investment paying 8%.
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.
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.
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.
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.