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 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 advisor can help you get a precise picture of your finances and guide you in making smart decisions with your money. Nominal Interest Rate BasicsInterest 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 advertisements 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 BasicsEconomists 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 RatesNominal 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 LineThe 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
Photo credit:©iStock.com/Deagreez, ©iStock.com/David Gyung, ©iStock.com/marchmeena29 Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons. Categories
What is the difference between nominal and real interest rates?A nominal interest rate refers to the total of the real interest rate plus a projected rate of inflation. A real interest rate provides the actual return on a loan (to the lender) and on a bond (to the investor).
What is the difference between nominal and real interest rates quizlet?The nominal interest rate is the rate you pay on a loan. The real interest rate is the nominal interest rate adjusted for inflation. a higher real interest rate reduces a borrowing firm's profit and hence its willingness to borrow.
Why are nominal and real interest rates different?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.
What is the difference between nominal and real interest rates Chapter 10?What is the difference between nominal and real interest rates? The real interest rate is the nominal interest rate adjusted for inflation, and the nominal interest rate is the rate you pay on a loan. Firms, households, and governments use the credit market for borrowing.
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What are the difference between nominal interest rate and real interest rate?
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