What is the Real Interest Rate?
The interest rate that accounts for the impact of inflation is known as the real interest rate. The rate determines how much money’s purchasing power has changed over time. The nominal interest rate is subtracted from the inflation rate to determine the real interest rate. For instance, the real interest rate would be 2% if you took out a loan with a nominal interest rate of 5% and the inflation rate was 3%. This indicates that over time, after considering the impacts of inflation, the purchasing power of the money you get from the loan will rise by 2%.
Because it displays the actual cost of borrowing money or the actual return on an investment, the real interest rate is significant. The purchasing value of the money you receive from the loan or investment will be higher than the purchasing power of the money you paid out when the real interest rate is positive. The purchasing power of the money you receive will be lower than the purchasing power of the money you pay out when the real interest rate is negative. When making financial decisions, it is crucial to take the real interest rate into account because it impacts the loan or investment’s long-term worth.
Real Interest Rate = Nominal Interest Rate – Rate of Inflation
Nominal vs Real Interest Rates
The portion of a loan that is charged to the borrower is called an interest rate, and it is often stated as an annual percentage. Lenders utilize interest rates to cover the risk they assume when making loans, and they can also be used to help keep inflation under control.