Definition of a Real Interest Rate

Interest rate reflects profit for someone.

Interest rate is the profit accrued on an investment or a financial instrument over time. There are two main types of interest rates in financial theory: nominal interest rate and real interest rate. Nominal interest is the reported rate of interest that is unadjusted to account for inflation. Real interest rate, also called adjusted interest rate, is the value of interest that is adjusted to remove the effects of all current and expected inflation. It reflects the actual cost of funds available to the borrower and the real yield payable to the lender. The real interest rate is the amount by which the nominal interest rate of an investment is greater than its inflation rate.

Nominal Interest Rate

Interest rate is the markup on the percentage of amount borrowed from a lender which is payable by a borrower. Most interest rates quoted on bank statements and other financial documents list the nominal interest rate: an unrealistic amount that is not adjusted to account for inflation. Inflation reduces the value of cash and other assets over time. The real interest rate keeps this fact in mind and subtracts the effect of inflation from the nominal interest rate to generate a more realistic picture of interest accrued on an investment.

Calculating Real Interest Rate

The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. This is denoted as:

Real interest rate = Nominal interest rate – Inflation rate (actual or expected)

Example

If the savings in a depositor's bank account earns 5 percent interest annually, and the inflation is currently 3 percent per year, then the real interest rate accrued on the account is 2 percent (5 percent minus 3 percent). This implies that the real value of a depositor's savings will increase by 2 percent annually, when its purchasing power is considered.

Significance

The real interest rate gives a more accurate picture of interest accrued on an investment. It allows financial and fund managers to determine the real rate of appreciation of an investment, after taking into account its accumulated inflation.

Negative Real Interest Rate

Negative real interest rate is when the rate of inflation is greater than the nominal interest rate. According to Richard E. Mshomba in the book “Africa in the Global Economy,” a negative real interest rate creates a disincentive to save, inhibiting credit availability.

References

• "The Strategic Bond Investor"; Anthony Crescenzi; 2002
• “Africa in the Global Economy”; Richard E. Mshomba; 2000
• "Macroeconomics: An Integrated Approach"; Alan J. Auerbach, Laurence J. Kotlikoff; 1998