financial literacy

Nominal vs Real Interest Rate

The nominal interest rate is the interest rate that is stated on a loan or mortgage and has not been adjusted for inflation. In investing, the nominal rate is the return on an investment before adjusting for inflation, fees or taxes.

Arundhati Sampath

23 Nov 2024 — 3 min read

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What is a Nominal Interest Rate?

Real Interest Rate

The Real interest rate takes into consideration the impact of inflation on the rate of return. In investing, the real interest rate helps compute your true rate of return after adjusting for inflation and taxes. It usually ends up being lower than the nominal rates and this effect compounds over longer time periods.

How to Calculate Real Interest Rates

The actual formula for real rate is as follows;

Real rate=(1+nominal rate)/(1+inflation)

Let us use an example to show how inflation affects real interest rates.

Assume you are investing $1000 in stocks and your annual rate of return is 8%. Sounds great right? Well, not so fast.

Example 1: If inflation is low, say 2%

Real interest rate = 5.88%

Your return at the end of one year is $58.8

Example 2: Now assume the inflation has been high in the past 1 year and was 4%.

Real interest rate = 3.84%

Your return at the end of one year is only $38.4

So you effectively earned less through your investment because of inflation.

How are nominal and real interest rates used for financial planning?

Investment analysis

The nominal rate allows you to compare the absolute returns on investments and understand how different investment options have performed before you factor in fees, taxes and inflation. You can compare between different assets and assess which ones perform better based on the nominal rates of return.

However, in order to figure out exactly the returns you earn on your investment, you need to factor in inflation, taxes or fees.This is where the real interest rate becomes really useful.

Evaluate cost of borrowing for loans & mortgages

The nominal rate is used to calculate the cost of borrowing on loans and debt. This is used in financial planning to calculate debt and mortgage payments while planning one’s finances. The real interest rate adjusts for inflation, so it tells you exactly how much you actually are paying on your loans and mortgages.

Planning for retirement or early retirement

You need to know what your exact returns are after inflation in the long term. Over time, inflation can eat into your returns and diminish your nest egg and affect when you will retire. So it is important to carefully evaluate your real rate of return when making retirement or early retirement decisions. Nominal rates of return may overstate your assets and be misleading. When you use real rates of return, you adjust for inflation and make sure you are really well positioned for retirement and your assets will last throughout your lifetime.

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