Difference Between Nominal Interest Rate & Real Interest
Many people assume that the advertised interest rate for an investment such as a certificate of deposit, a bond or a savings account is the actual increase in the value of their assets. While mathematically true, the actual purchasing value of their assets can increase or decrease over time because of inflation.
Other People Are Reading
-
What Is a Nominal Interest Rate?
-
The nominal interest rate is the actual percentage used to calculate the interest that a financial product such as a savings account or certificate of deposit will yield. For example, if a savings account has an interest rate of 5 percent, then the money in that savings account will grow by 5 percent per year.
What Is Inflation?
-
Inflation is the amount (expressed as a percentage) that the cost of goods and services increases over a year. The inflation rate in the United States is usually referenced by the Consumer Price Index, or CPI.
-
What Is the Real Interest Rate?
-
The real interest rate is the nominal interest rate minus inflation; if the nominal interest rate is 5 percent per year and inflation is 3 percent per year, then the real interest rate will be 2 percent per year. This real interest rate is the actual increase in buying power an investor gets after both the nominal interest rate and inflation are taken into account.
Why Is the Real Interest Rate Important?
-
As a result of inflation, the cost of goods and services historically increases over time and the buying power of a dollar decreases. The real interest rate is used to determine the real appreciation in an investment after inflation is taken into consideration.
How Investors Can Combat Inflation
-
Since inflation chips away at the nominal interest rate earned, many investors look for ways to make sure that the interest rate that they earn keeps up with inflation. One way is to invest in a product called Treasury Inflation Protected Securities, or TIPS--the interest rate paid on TIPS rise and fall as inflation increases and decreases.
-
