The Importance of Differentiating Between Real Interest & Nominal Interest Rate

Real interest rates reflect inflation.

There are two main ways of calculating the rate of return on a loan. The first measures the nominal interest rate of a loan, providing the precise figure that the investor will receive if the loan is repaid. The second, the real interest rate, factors in inflation.

Features

Loans can have long lives, with payments stretching over several decades. Over time, inflation will likely increase, decreasing the purchasing power of the currency in which the loan is denominated. The "real" interest rate of a loan is the interest rate adjusted to reflect this shift.

Effects

Real interest rates are calculated by subtracting the anticipated yearly rate of inflation from the yearly interest rate. The final figure will express the cost to the borrower and the yield to the lender in terms of the actual purchasing power of the interest paid on the loan.

Significance

If a borrower does not factor inflation into his calculations about the cost of a loan, he will not be able to determine how much he is spending to borrow money. If a lender does not factor in the real inflation rate, he can't know what he can expect to recoup on his investment.

References

• Library of Economics and Liberty: Real vs. Nominal
• Investopedia: Real Interest Rate
• Finance Scholar: Real and Nominal Interest Rates - Factoring in Inflation