The nominal interest rate is the simple interest charged on a loan or paid on a deposit. Real interest is nominal interest after taking inflation’s effects into account. Economists, as well as lenders and borrowers, calculate real interest to get a more accurate picture of the profit on a loan or deposit after accounting for changes in purchasing power. Real interest is especially important when dealing with long-term deposits and loans, because inflation’s effects are compounded over time.
A qualified financial advisorcan help you get a precise picture of your finances and guide you in making smart decisions with your money.
Nominal Interest Rate Basics
Interest is the cost to borrow money, as well as the profit when lending money. The interest rate is a prime consideration when evaluating a credit card offer, a mortgage, an auto loan, a savings account or a certificate of deposit.
The nominal interest rate is the most basic way to state the amount of interest applied to a deposit or loan. The nominal interest rate may also be called the simple interest rate. It is used with uncomplicated loans when the interest rate is applied to the principle for the term of the loan. For example, with a nominal interest rate of 8%, a one-year loan of $1,000 will cost $80. At the end of the year, the borrower pays back $1,080.
Nominal interest is also sometimes called the advertised rate or the stated interest rate. That is because financial institutions may use it in promotions for loans or deposits or in loan documents.
Not all advertisem*nts refer to nominal interest rates, however. Financial institutions such as banks and credit unions, also often state annual percentage yield (APY) for deposits and annual percentage rate (APR) for loans. These interest rates include the effects of other factors, such as compound interest and fees that come into play with more complex transactions such as mortgage loans. The APR and APY will generally be higher than the nominal interest rate.
Real Interest Rate Basics
Economists often employ real interest rates rather than nominal interest rates. Real interest rates account for the effects of inflation. Inflation reduces the purchasing power of future dollars. Including the effects of inflation gives a more accurate picture of the real cost of a loan for a borrower. Depositors can also use real interest to get a clearer idea of the return on an interest-bearing investment.
To approximate the real interest rate, subtract the inflation rate from the nominal interest rate. For example, if the inflation rate is 5%, on a one-year loan of $1,000 with an 8% nominal interest rate the real interest rate would be 8% minus 5% or 3%. The real interest rate will usually be lower than then nominal interest rate.
Other Interest Rates
Nominal interest rates and real interest rates are just two of several types of interest rates that may come up when evaluating an investment or a loan. Another useful interest rate is the effective interest rate or effective annual rate, which includes the effects of compounding.
Many loans and deposits calculate interest more often than once a year, such as semiannually, quarterly or daily. This is called compounding, and when a loan or deposit employs compounding, the interest earns interest. Compounding can have a meaningful effect on the cost of a loan or return on an investment over time.
Bottom Line
The nominal interest rate is a simple way of expressing the cost of a loan or the return on a deposit. The real interest rate accounts for the effect of inflation on the purchasing power of dollars used to repay a loan or as profit on an investment. Neither the nominal interest rate nor the real interest rate will always fully account for the actual cost of many loans, including credit cards, lines of credit, mortgages and auto loans. Other factors, including fees and compounding of interest, can also significantly increase the cost of loans, especially over longer periods of time.
Financial Planning Tips
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What Is Nominal Interest Rate? Nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.
equals the real interest rate plus a projected rate of inflation. A real interest rate reflects the true cost of funds to the borrower and the real yield to the lender or to an investor.
The nominal interest rate, or coupon rate, is the actual price borrowers pay lenders, without accounting for any other economic factors. The real interest rate accounts for inflation, giving a more precise reading of a borrower's buying power after the position has been redeemed.
The simple equation used is i - p = r. Nominal rate - i, Inflation - p, Real rate - r. The real rate would be greater than the nominal if the inflation rate is negative, meaning prices at one time period are lower in the following time period. This is know as deflation.
The nominal interest rate does not take into account the compounding period.The effective interest rate does take the compounding period into account and thus is a more accurate measure of interest charges. A statement that the "interest rate is 10%" means that interest is 10% per year, compounded annually.
For example, nominal interest rates indicate what we'd be charged for a loan, but the real interest rate can help us decide whether or not the loan is too costly for our budgets. As far as purchasing power goes, a real interest rate that's positive is always good, unless the inflation rate is greater.
The nominal value is the current value, without taking inflation or other market factors into account. It is the face value of the good. The real value is the nominal value after it has been adjusted for inflation.
A real interest rate equals the observed market interest rate adjusted for the effects of inflation. It reflects the purchasing power value of the interest paid on an investment or loan.
The lender's real return drops as a result of a faster decline in the purchasing power. If the nominal interest rate and expected inflation rate both increase at the same rate, which means the inflation premium is compensated, the real interest rate will remain unchanged.
Effective interest rate is the one which caters the compounding periods during a payment plan. It is used to compare the annual interest between loans with different compounding periods like week, month, year etc. In general stated or nominal interest rate is less than the effective one.
The most important factor you have control over is your credit score. Your credit score helps lenders determine how much they trust you to repay your debts. Typically, the higher your credit score, the lower your interest rate. If you don't know your credit score, which ranges from 300 to 850, find out.
When inflation is 3 percent, and the interest rate on a loan is 2 percent, the lender's return after inflation is less than zero. In such a situation, we say the real interest rate—the nominal rate minus the rate of inflation—is negative.
Investors need to understand the difference between nominal and real returns to gauge how well their investments are truly performing in protecting their buying power. Simply put, a nominal return is the total rate of return on an investment before deducting inflation, taxes, trading costs and investment fees.
However, nominal interest does not take account of inflation. Inflation erode the purchasing power of money. A high inflation rate will mean that any investment gains may not benefit the investor as the currency will have weakened. The real interest rate considers inflation rates.
Higher interest rates have gotten a bad rap, but over the long term, they may provide more income for savers and help investors allocate capital more efficiently. In a higher-rate environment, equity investors can seek opportunities in value-oriented and defensive sectors as well as international stocks.
In the Fisher effect, the nominal interest rate is the provided actual interest rate that reflects the monetary growth padded over time to a particular amount of money or currency owed to a financial lender. Real interest rate is the amount that mirrors the purchasing power of the borrowed money as it grows over time.
Nominal interest rates are the interest rates that have not been adjusted for the impact of inflation .Real interest rates are those that have been adjusted for the impact of inflation. The equation for nominal interest rates is real interest rate + inflation.
Difference between a nominal and real interest rate is as follows: Nominal interest rates are adjusted before inflation or adjusted for inflation and real interest rates are not adjusted for inflation but adjusted to eliminate the effects of inflation for giving real rate of loan or bond.
The nominal interest rate, also known as an annual percentage rate or APR, is the periodic interest rate multiplied by the number of periods per year. For example, a nominal annual interest rate of 12% based on monthly compounding means a 1% interest rate per month (compounded).
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