Difference Between the Real And Nominal Interest Rate
1. Nominal Interest Rate
The nominal interest rate is the simplest type of interest rate. It is the stated interest rate of a given bond or loan. The nominal interest rate is in the actual monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them.
But the nominal interest rate doesn’t take inflation into account.
2. Real Interest Rate
Now imagine that the inflation rate was 5%. A 5% inflation rate means that an average basket of goods you purchased this year is 5% more expensive when compared to last year.
Continuing with our previous example, the lender would make nothing if he loaned it out at 5% when the rate of inflation was 5%.
Real and Nominal Interest Rate Formula
The approximate formula is Real Interest Rate (R) = Nominal Interest Rate (r) – Rate of Inflation (i)
The more precise formula is:
(1+ (R)) = (1+ (r)) / (1+ (i))
This means that when the rate of inflation is zero, the real interest rate is equal to the nominal interest rate. With positive inflation, the nominal interest rate is higher than the real interest rate. Effectively, the real interest rate is the nominal interest adjusted for the rate of inflation. It allows consumers and investors to make better decisions about their loans and investments.
Example: If the rate of inflation is at 3%, and the real interest rate is 2%, then the nominal interest rate would be 5%.