Definition of the Nominal Interest Rate

The nominal interest rate is the term for the expressed interest rate for an investment or security, or the interest rate paid on a loan.

Nominal Interest Rate

The nominal interest rate is the rate borne by the investment or debt instrument. For instance, the nominal interest rate for a 5 percent U.S. savings bond is simply 5 percent (ignoring, for the sake of simplification, the effects of compounding).

Real Interest Rate---Inflation Adjustment

The real interest rate is the nominal interest rate, adjusted for inflation. For example, an investment paying 5 percent annual interest in an economic climate where inflation is expected to be 3 percent a year, bears a real interest rate of 2 percent.

Formula for Calculating Real Interest

To calculate the real interest rate, use this formula: Real interest rate = Nominal interest rate - expected inflation.

What Real Interest Rate Means for Investors

The real return on an investment consisting of a debt instrument, such as a T-bill or a corporate bond, is equivalent to the real interest rate. Thus, if annual inflation actually exceeds the nominal interest rate on an investment, that investment is actually losing money.

What Real Interest Rate Means for Borrowers

The true interest cost for a loan is the real, not the nominal, interest rate. Thus, if annual inflation exceeds the interest rate on a loan, that loan has no actual cost, and in fact, makes money for the borrower.

References

• Further Explanation of Nominal vs. Real Interest Rate