What Is the Definition of a Real Interest Rate?
Go beyond stated rates to understand the actual purchasing power of your money over time. Learn how to assess genuine financial outcomes.
An interest rate represents the price associated with borrowing money or the return received when lending funds. It is typically expressed as a percentage of the principal amount over a specific period, often annually. For individuals, this rate determines the cost of a mortgage or car loan and the earnings on savings accounts or certificates of deposit. Businesses also consider interest rates when securing financing for operations or expansion.
Understanding Nominal Interest Rates
The nominal interest rate is the stated or advertised rate on a loan or investment. It is the rate displayed in loan advertisements or when opening a savings account. For example, a bank might advertise a savings account offering a “2% annual interest rate” or a mortgage with a “6% interest rate.”
It is calculated solely on the principal sum, reflecting the direct cost for borrowers and the earnings for lenders. This figure does not account for changes in the purchasing power of money over time.
The Impact of Inflation
Inflation refers to the rate at which the general level of prices for goods and services rises across an economy. As prices increase, the purchasing power of each unit of currency decreases, meaning a fixed amount of money buys fewer goods and services over time.
Consider a scenario where a basket of groceries costs $100 today. If inflation is 3% over the next year, that same basket of groceries will cost $103 a year from now. Inflation can significantly impact the real value of wages and savings.
Calculating the Real Interest Rate
The real interest rate provides a more accurate picture by adjusting the nominal interest rate for the effects of inflation. It represents the true return for a lender or investor, or the true cost for a borrower, in terms of purchasing power.
To determine the real interest rate, the inflation rate is subtracted from the nominal interest rate. The formula is: Real Interest Rate = Nominal Interest Rate – Inflation Rate. For instance, if a savings account offers a 5% nominal interest rate and the inflation rate is 3%, the real interest rate is 2% (5% – 3% = 2%).
A positive real interest rate indicates an increase in purchasing power, meaning your money can buy more in the future. Conversely, a negative real interest rate occurs when inflation outpaces the nominal rate, resulting in a decrease in purchasing power despite earning interest.
Significance of the Real Interest Rate
Understanding the real interest rate is important for various financial decisions, as it clarifies the actual economic impact of interest. For savers and investors, it reveals the true growth of their money. A high real interest rate means their purchasing power is genuinely increasing, making saving and certain investments more appealing.
For borrowers, the real interest rate signifies the actual cost of their debt. A lower real rate means the true burden of repayment is less in terms of purchasing power, potentially encouraging borrowing for significant purchases like homes or vehicles. Conversely, higher real rates make borrowing more expensive.
Across the broader economy, real interest rates influence spending, saving, and investment patterns. Central banks and policymakers monitor these rates to assess economic conditions and guide monetary policy.