What Is the Real Interest Rate and Why Does It Matter?
Learn what the real interest rate is and why it's essential for understanding the true economic impact of your money.
Interest rates are a fundamental concept in finance, influencing everything from the cost of a home loan to the return on a savings account. They represent the price of borrowing money or the reward for lending it. While individuals commonly encounter interest rates in their daily financial dealings, the stated rate does not always tell the whole story about the true value of money over time. Understanding the real interest rate is important for anyone looking to comprehend the actual cost of borrowing or the genuine return on savings.
Nominal Interest Rates and Inflation
The nominal interest rate is the stated or advertised interest rate on a loan or investment, without any adjustments for inflation. It is the rate that borrowers agree to pay and lenders expect to receive, typically expressed as a percentage of the principal amount over a specific period, such as a year. For instance, a savings account offering a 2% annual interest rate or a car loan with a 6% interest rate are examples of nominal rates.
Inflation refers to the rate at which the general level of prices for goods and services increases over time, leading to a decrease in the purchasing power of currency. For example, if inflation is 3%, an item that cost $100 last year would now cost $103 to purchase. This erosion of purchasing power means that money held over time loses some of its value, affecting both savings and debt.
The interplay between nominal interest rates and inflation is important because it dictates the actual economic outcome for individuals and the economy. A high nominal interest rate might seem attractive for savers, but if inflation is equally high or higher, the real value of their savings could still diminish. Similarly, a borrower might pay a certain nominal rate on a loan, but inflation can impact the true burden of that debt over time.
The Real Interest Rate Defined
The real interest rate provides a more accurate measure of the return on an investment or the cost of borrowing. It represents the nominal interest rate adjusted to account for the effects of inflation. This adjustment reveals the true increase or decrease in purchasing power that an investor gains or a borrower pays.
The real interest rate shows how much an investment truly grows in terms of purchasing power after accounting for rising prices. For a saver, a positive real interest rate means their money is growing faster than inflation, allowing them to buy more goods and services in the future. Conversely, a negative real interest rate indicates that inflation is eroding the value of their money faster than it is earning interest, resulting in a loss of purchasing power.
For borrowers, the real interest rate reflects the true burden of their debt. If the real interest rate is low or negative, the actual cost of borrowing is less significant because inflation is reducing the real value of the repayments over time. A higher real interest rate, however, means the borrower is paying a substantial cost for the loan, even after considering inflation.
How to Calculate the Real Interest Rate
The most commonly used formula for this calculation is known as the Fisher Equation. This equation states that the real interest rate is approximately equal to the nominal interest rate minus the inflation rate.
The formula can be expressed as: Real Interest Rate ≈ Nominal Interest Rate – Inflation Rate. To illustrate, consider an example where a savings account offers a nominal interest rate of 5% per year, and the annual inflation rate is 3%. Using the formula, the real interest rate would be approximately 5% – 3% = 2%. This means that after accounting for the increase in prices, the purchasing power of the money in the savings account is growing by about 2% annually.
Another example involves a loan with a nominal interest rate of 7% and an inflation rate of 4%. In this scenario, the real interest rate is approximately 7% – 4% = 3%. This indicates that the true cost of borrowing, in terms of purchasing power, is about 3% per year.
Significance of the Real Interest Rate
Understanding the real interest rate is important for various participants in the economy, including savers, investors, and borrowers, as it provides a clearer picture of financial outcomes. For savers and investors, the real interest rate determines the actual growth of their wealth and its purchasing power over time. A positive real return means their money’s ability to buy goods and services is increasing, while a negative real interest rate implies inflation is eroding their savings.
For borrowers, the real interest rate impacts the true cost of their loans. A low or negative real interest rate lessens the burden of debt repayment, making borrowing more attractive for large purchases. Conversely, a higher real interest rate means the actual cost of servicing the debt is greater, influencing decisions on new loans.
From a broader economic perspective, the real interest rate serves as an important indicator for economic analysis and decision-making. It influences spending and investment patterns across the economy. A low real interest rate can encourage businesses to borrow and invest in new projects, stimulating economic activity, while a high real interest rate can temper such enthusiasm. This metric provides insights into the true cost of capital and the real return on investment opportunities.