Nominal vs Real Interest Rates

Difference Between Nominal vs Real Interest Rates

Interest rates are a very crucial part of financial instruments and the financial industry as a whole. They help the investors and financial managers to make the decision in choosing the right instruments for their needs and risk profile. But simply analyzing the interest rates will not suffice for long term investments as inflation also plays a major role in that. This is the reason we have two types of interest rate: Nominal Interest Rates and Real Interest rates. Let us dig deep and understand both Nominal vs Real Interest rates.

Nominal Interest Rates

Nominal interest rates are the rate of return which an investor or borrower will get or have to pay in the market without any adjustment for inflation. For example Rate of interest on bank accounts, bonds, loans, etc. all are nominal interest rates. It is really easy to understand, for example: if you have deposited $100 in your bank account and your bank is offering a 5% per annum interest rate, you will have $105 (100 + 0.05*100 ) in your account by end of the year. Similarly, if you have borrowed $100 from someone and he is charging 3% interest, you have to pay back $103 at the end of the year.

Real Interest Rates

Nominal interest is a quite an easy concept to understand. But when we see the effect of inflation on top of that, things become more interesting. Continuing the above example, depositing money in a bank will give us 5% interest and we will earn $5 in interest. But if the inflation is 3% per annum, it means that goods and services which we can buy at, say $100, we have to pay $103 now for the same amount of goods and services. So effectively, we have earned only $2 ($5 – $3). So basically, real interest rates will give the real picture of the purchasing power of the consumer.

Head to Head Comparison between Nominal vs Real Interest Rates (Infographics)

Below is the top 6 difference between Nominal vs Real Interest Rates:

Key Differences between Nominal vs Real Interest Rates

Although both Nominal vs Real interest rates give us the idea of what we can earn on investment or need to pay if we take up any loan; let us discuss some of the major differences :

1. As discussed earlier, the nominal interest rate is the market rate of return/interest that will be earned by/charged to the customer, while the real interest rate is the effective rate that an investor will realize.
2. The nominal interest rate has no effect of inflation incorporated in it while the real interest rate is calculated after removing the inflation effect.
3. Bank interest rates, loan interests, etc. all are nominal interest rates. Real interest rates are basically derived from nominal rates.
4. A real interest rate is basically based on the principle of the time value of money, inflation, etc. will change the value of money continuously with time, this effect will get captured in real rates. No such adjustments happen in nominal rates.
5. A nominal rate cannot be negative and can only go down to 0% while the real rate can be negative. For example: If the nominal rate in the market is 3% but inflation itself is 5%, effectively, the investor will lose money and will have a negative real interest rate.

Nominal vs Real Interest Rates Comparison Table

Let’s look at the top 6 Comparison between Nominal vs Real Interest Rates

Conclusion

Nominal interest rates are the tools present in the market to determine the return on investment or cost of borrowed money. All the financial institutions, banks, corporations, etc. quote nominal interest rates. But, in actual life, the real interest rate plays a more crucial role than the nominal rate. The real interest rate provides us a relatively clearer and real picture of the actual amount of money/return one can earn on its investments over time. It also makes the borrower aware in terms of the actual cost he has to bear when he takes up the loan. Real interest rates can help in deciding when to pay back the loan; is it beneficial to repay early or to continue as it is. So, in a nutshell, investors should keep an eye on both nominal vs real interest rates. Nominal interest rates will tell him what is prevailing in the market and how the market is moving. Real rates will tell him what actual returns he can make from the market to grow his capital.

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