How to Calculate Real Interest Rates

Real interest rates are an easy to calculate and important key to lending. Real interest rates eliminate the effect of inflation by subtracting an inflation index from an interest rate. Real interest rates reflect the profit margin of the lender after taking into account the rate of inflation. The resulting calculation is a true measure of profit available to the lender for the use of money over time. Historically, real interest rates have averaged about 3 percent above the rate of inflation for high quality debt.

Difficulty: Challenging

Instructions

1. Derive a simple calculation of real interest rates by subtracting the rate of inflation from the nominal interest rate (the current interest rate). The real interest rate is the rate of interest necessary for borrowers and lenders to conduct business without any expectation of inflation. If government bond rates are at 5% and inflation is 4% then the real rate of interest is 1%.

2. Compute more realistic rates of interest by substituting the general rate of inflation for a more appropriate sector measure. For example, rather than using a national rate of inflation in a study of industrial growth use an appropriate industry sector such as the wholesale rate of inflation. These statistics are kept by the Bureau of Labor Statistics and other government agencies.

3. Compute specific real interest rates. Know the appropriate interest rate that represents the appropriate time-frame. For example, use a 30 year mortgage rate if you are measuring home mortgage rates. Use a 5 year bank lending rate if you are buying a car. Use a rate that reflects the most likely cost of money given credit and maturity considerations.

4. Annualize the monthly rate of nominal inflation by subtracting the rate of increase for the previous month (say .4 percent) and multiplying by twelve: (.4 percent x 12 = 4.8 percent). Subtract this number from the nominal interest rate to obtain an instantaneous rate of interest.

5. Compute the positive or negative rate of return to your investment. If you buy a car with a 5% loan and you compute that the nominal rate of inflation is 6 percent then your real rate of interest is -1 percent. This implies that you are effectively making 1 percent per year because your cost of money is exceeded by the inflation adjusted rate of money.

6. Know that lenders expect a real rate of return in order to make loans. If interest rates are negative expect an increase in rates or a decline in inflation. Remember that interest rates are composed of both the real and the inflation adjustment rates. Combine the rates to reach a rate of nominal interest rates.

Tips & Warnings

• The real interest rate in most cases varies by geographical area and political framework. Interest rates are often used as a public policy tool.

Resources

• Bureau of Labor Statistics CPI Index