When money is borrowed from a bank, it is returned to the bank with a little extra amount in addition to the principal borrowed amount. This extra amount of money paid to the bank is called interest.
The amount of money to be paid as interest depends on the interest rates fixed by banks.
Key Takeaways
- The nominal interest rate refers to the unadjusted interest rate on a loan or investment, while the real interest rate accounts for inflation.
- Real interest rate provides a more accurate representation of the true cost of borrowing or the real return on investment.
- To calculate the real interest rate, subtract the inflation rate from the nominal rate using the Fisher equation.
Nominal vs Real Interest Rate
The nominal interest rate is the rate of interest that does not take the inflation rate into account. Over time, the interest rate is stable and will never be a negative value. The real interest rate is the rate of interest that takes adjustment for inflation into account. The interest is low, unstable and can be of a negative value. It is an accurate indicator of market price.
The nominal interest rate is fixed at the time of disposal of money to the borrower by the lender. It is the rate at which money is being repaid to the bank.
It is decided at the time of the transaction and does not change over time.
This is because it does not take money or economic inflation into account.
The real interest rate is the actual interest rate at which a borrower pays back money to the bank instead of the accounting factors like inflation that change the rate of interest to be paid.
This rate of interest, hence, is a more accurate form of repayment to the banks as the rate is adjusted in case of inflation.
Comparison Table
| Parameters of Comparison | Nominal Interest Rate | Real Interest Rate |
|---|---|---|
| Also Called | The other name for the nominal interest rate is also the coupon rate. | The real interest rate is also called an actual interest rate. |
| Inflation | The nominal interest rate is fixed without the influence of inflation. | The rate is real interest is fixed with levels of inflation in mind. |
| Amount | Usually, the interest is high in nominal interest rate. | Usually, the interest is low in real interest rate. |
| Stability | Stability is a feature of the nominal interest rate. | Flexibility is a feature of the real interest rate. |
| Adjustment | The nominal interest rate can never be a negative measure. | The real interest rate can be a negative measure if certain conditions prevail. |
What is Nominal Interest Rate?
The nominal interest rate is the rate of interest decided during the acquisition of a loan from a bank. It is decided at the time of issue of the loan and remains steady until the recovery of the loan.
Thus, a nominal interest rate is a predefined rate of interest on a particular sum of money issued by the bank to a borrower.
The nominal interest rate is made with consideration of demand and supply chains and inflation of the last financial year. It does take into account the inflation changes during the term of the loan.
The market is a fluctuating entity, and inflation rates change from time to time. Hence, nominal interest rates are also not an accurate rate of interest.
Usually, only if the nominal interest rate is accounted for then the borrower has to repay a larger amount of sum to the bank, as inflation reduces the rate of interest on any amount.
Thus with the nominal interest rate, you can be sure of the minimum payment that you have to pay back to the bank as the rates of interest do not change.
Nominal interest rates depend upon a lot of factors like risk rate, supply and demand chain, and other factors that affect the money market and the bank itself.
Usually, all rates are low when there is ample money in circulation and with the bank, and this can be known by keeping a look at the bank’s previous three or five-year rate sheet.
What is Real Interest Rate?
Interest rates and inflation are set by central banks in a country at a specific level where it is considered to be a stable macroeconomic scenario.
So, inflation is considered one of the major economic indicators which indicate the stability of the country’s economy.
It is the central bank’s responsibility to increase or decrease the interest rates based on the economy.
Inflation is a major determinant of the general price level of goods and services in an economy and is determined by monetary authorities through controlling the money supply.
Inflation represents a loss of real value from the medium of exchange and all nominal assets, a loss that increases the purchasing power of money – a phenomenon that a price index measures.
Thus, when inflation occurs, the rate of interest must go down as most things become cheaper. Thus, with the real interest rate, you have to pay the correct amount of interest back to the value of goods in the market.
Thus, although unstable, the real interest rate is a more accurate description of the market value of goods and the amount needed to be returned by you for the amount lent but for a bank.
Main Differences Between Nominal and Real Interest Rate
- The nominal interest rate is stable over time and adjusted only at the end of the loan, while the real interest rate, due to its flexibility, changes by market inflation.
- Nominal interest rates can never be of a negative value, while real interest rates can become a negative value if inflation occurs in the market, which makes the prices go much below normal.
- The nominal interest rate is not an accurate marker of the market price of goods and services, whereas the real interest rate is an accurate market price marker.
- A nominal interest rate is made without taking inflation into account, whereas real interest rates are determined keeping inflation in mind.
- The nominal interest rate makes the borrower pay a larger sum of money than the real interest rate to repay the same amount of loan.
Last Updated : 13 February, 2024
I’ve put so much effort writing this blog post to provide value to you. It’ll be very helpful for me, if you consider sharing it on social media or with your friends/family. SHARING IS ♥️
Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
The comparisons drawn in this post are quite insightful. It effectively highlights the key differences between nominal and real interest rates.
This is a rather intriguing comparison. The comprehensive explanation of nominal and real interest rates allows readers to gain a clearer understanding of the topic.
This is quite an informative read! It’s always good to refresh our knowledge of basic financial concepts. I appreciate the easy-to-understand breakdown.
I think this post makes some valid points about nominal and real interest rates. However, the discussion regarding real interest rates could be further elaborated upon to provide a deeper understanding.
I’m glad to see this simple and concise explanation on nominal vs real interest rate. As a novice in the financial world, I find this quite helpful. Thank you for sharing!
I believe that the real interest rate is a better measure of the true cost of borrowing than the nominal interest rate. The inclusion of inflation rates provides a more accurate representation. Well explained!
I appreciate the detail in this post. It certainly helps in understanding the concepts of nominal and real interest rates.
It’s quite interesting to note the differences between nominal and real interest rates. The section which outlined ‘What is Real Interest Rate?’ was particularly illuminating.