Definition
The Real Interest Rate is the rate of interest an investor, saver or lender receives, or expects to receive, after allowing for inflation. It adjusts the nominal interest rate, which just mirrors money’s time value, to compensate for the effect of inflation on money’s purchasing power. Essentially, it is the growth rate that a certain investment or saving will have after considering the reducing effect of inflation.
Key Takeaways
- The Real Interest Rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or investor.
- It provides an accurate picture of the interest rate by factoring out the erosion of purchasing power that inflation causes, thus accurately measuring the true earning potential of a particular form of investment or loan.
- Real interest rates can be negative if inflation rates exceed nominal interest rates, which results in the lender earning less profit than expected or even losing money.
Importance
The Real Interest Rate is a critical financial term because it expresses the rate of interest an investor anticipates or a borrower pays after accounting for inflation.
It reflects the true earning potential of a particular investment, or the actual cost of borrowed funds.
Unlike the nominal interest rate, it reveals the purchasing power obtained through interest earnings or lost through loan payments.
By using the real interest rate, investors or borrowers can make more accurate financial decisions as it indicates the real rate of return on an investment or cost of borrowing in terms of goods and services rather than a monetary unit.
Thus, in financial planning and policy-making, the real interest rate is crucial.
Explanation
The Real Interest Rate serves as a pivotal indicator for economists, investors and policymakers, allowing them to better gauge the performance and prospective trajectory of an economy. Essentially, it eliminates the effect of inflation and gives a more accurate understanding of the financial benefits that an investor will earn or the financial costs a borrower will bear. Hence, it is highly beneficial in making economic decisions, whether on individual investments or on policy levels.
Considered as a base tool for stimulating economic activity, real interest rate holds high relevance. When real rates are low, borrowing costs are low as well, enabling individuals and businesses to borrow more affordably. This would lead to higher spending and investments, stimulating economic growth.
Conversely, high real rates make borrowing more expensive, slowing down economic activity. Central banks often manipulate nominal rates to steer real rates, respond to economic conditions, and guide economy towards desirable growth and inflation. Therefore, the real interest rate is a critical element in managing economic conditions and facilitating financial planning and investment decision-making.
Examples of Real Interest Rate
Housing Loans: If a bank lists the nominal interest rate for a mortgage as 5%, and the inflation rate that year is 3%, that means the real interest rate you’re paying on your mortgage would be approximately 2% (5% – 3%). This is the rate at which the amount you owe is actually increasing in real terms.Savings Accounts: If you’re earning 2% interest annually on your savings account, but inflation for that year is
5%, your savings is only growing in real terms by5%(2% –
5%). So while the amount in your account is increasing, the purchasing power of that money is not increasing by much due to inflation.Government Bonds: Suppose you bought a 10-year government bond with a 4% nominal interest rate. If the average inflation during this 10-year period is 2%, your real return (Real Interest Rate) from this bond investment would be approximately 2% (4% – 2%). Hence, your investment’s actual growth is less than the nominal interest rate due to effect of inflation.
FAQs about Real Interest Rate
What is Real Interest Rate?
The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It is the growth rate of purchasing power derived from an investment.
How is Real Interest Rate calculated?
Real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. The formula is: Real Interest Rate = Nominal Interest Rate – Inflation Rate.
What is the difference between Nominal Interest Rate and Real Interest Rate?
Nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest. The real interest rate is the nominal rate minus the rate of inflation.
Why is Real Interest Rate important?
Real interest rates provide important insights into the health of an economy. If the real interest rate is negative, it means that people are effectively losing wealth by saving money. Conversely, if the real interest rate is too high, it could discourage investment as borrowing costs become too expensive.
Does Real Interest Rate affect consumers?
Yes, the real interest rate can have a big impact on consumers. It affects the rates they receive on savings accounts and the rate they pay on loans. A low real interest rate can encourage people to spend more, while a high real interest rate can encourage people to save more.
Related Entrepreneurship Terms
- Nominal Interest Rate
- Inflation Rate
- Purchasing Power
- Monetary Policy
- Capital Erosion
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Sources for More Information
- Investopedia: This website offers a vast amount of information on financial terms including real interest rate.
- The Federal Reserve: The central bank of the United States provides detailed explanations on economic and financial indicators, including real interest rates.
- International Monetary Fund : IMF offers vast financial information, papers, reports, including detailed topics like real interest rates.
- The World Bank: This international financial institution provides data and resources about various economic and financial topics, including real interest rates.
