# Nominal vs. Real Interest Rate: What’s the Difference?

## Nominal vs. Real Interest Rate: An Overview

Interest rates represent the cost of borrowing and the return on savings and investing. They’re expressed as a percentage of the total amount of a loan or investment. They can be the total return lenders receive when they offer loans or the return people earn when they save and invest.

Interest rates can be expressed in nominal or real terms. A nominal interest rate 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.

### Key Takeaways

• Interest rates represent the cost of borrowing or the return on saving, expressed as a percentage of the total amount of a loan or investment.
• 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).
• To calculate the real interest rate, subtract the actual or expected rate of inflation from the nominal interest rate.
• Nominal interest rates can indicate current market and economic conditions while real interest rates represent the purchasing power of investors.

## Nominal Interest Rate

The nominal interest rate is the rate that is advertised by banks, debt issuers, and investment firms for loans and various investments. It is the stated interest rate paid or earned to the lender or by investor. So, if as a borrower, you get a loan of \$100 at a rate of 6%, you can expect to pay \$6 in interest. The rate has been marked up to take account of inflation.

Nominal Interest Rate = Real Interest Rate + Projected Rate of Inflation

Short-term nominal interest rates are set by central banks. These rates are the basis for other interest rates that are charged by banks and other institutions on, e.g., loans to consumers and credit card balances. Central banks may decide to keep nominal rates at low levels in order to spur economic activity.

Low nominal rates encourage consumers to take on more debt and increase their spending. This was the case following the Great Recession when the U.S. Federal Reserve dropped the federal funds rate to a range of 0% to 0.25%. The rate remained in this range between December 2008 and December 2015.

It’s important to understand that to obtain the real short-term federal funds rate, one would subtract the inflation rate from the nominal rate. For example, the personal consumption expenditure (PCE) rate, which is the rate that the Fed focuses on to gauge inflation, could be subtracted.

Typically, that will result in an actual lower fed funds rate that’s more stimulative for the economy than is the published, nominal rate usually referred to by media and the government.

The term nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.

## Real Interest Rates

A real interest rate is the interest rate that is added to the projected rate of inflation to provide the nominal interest rate. Put simply, this interest rate provides insight into the actual return received by a lender or investor after a rate of inflation is acknowledged. This type of rate is considered predictive when the true rate of inflation is unknown or expected.

Investors can estimate the real rate of return by comparing the difference between a Treasury bond yield and a Treasury Inflation-Protected Securities (TIPS) yield of the same maturity, which estimates inflation expectations in the economy.

You can also calculate the real rate of interest associated with a credit or investment product. To do so, you first need the nominal rate and an actual or estimated rate of inflation:

Real Interest Rate = Nominal Interest Rate – Projected Rate of Inflation

The formula above is derived from the Fisher Effect. Developed by economist Irving Fisher in the 1930s, it’s the theory that interest rates rise and fall in direct relationship to changes in inflation rates. It suggests that the real interest rate—or the return received by lenders and borrowers—drops as inflation rises, until nominal interest rates rise in conjunction with inflation.

Suppose a bank lends \$200,000 to a homebuyer at a nominal rate of 3%. Assume the inflation rate is 2%. The real interest rate that the borrower pays is 1%. The real interest rate that the bank receives is 1%. While that rate of borrowing may be fine for the homebuyer, it may not be profitable for the lender.

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