What is Real Interest Rate?

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Definition:

A real interest rate is an interest rate that reflects the effect of inflation on money’s value and how that impacts the cost of borrowing and lending money, offering a more accurate portrayal of interest costs.

🤔 Understanding real interest rate

A real interest rate is an interest rate that reflects how inflation makes money less valuable over time, letting it show the cost of borrowing and lending more accurately than nominal interest rates do. Over time, money tends to become less valuable through the process of inflation. Often, inflation is expressed as a percentage rate. For example, if inflation is 2% per year, it would take $102 to buy the same goods that $100 bought the year before. Interest rates are also portrayed as a percentage. The balance of $100 loan at a 3% annual rate would increase to $103 if the borrower makes no payments. Real interest rates adjusts the interest rate for the effects of inflation to portray the actual value of the amount added to a loan’s balance in interest.

Example

Imagine a borrower gets a $10,000 loan from a bank. The bank charges 5% interest per year. The annual rate of inflation is 3%, which means that after one year, a dollar will be 3% less valuable than it was at the beginning of the year. Assuming the borrower makes no payments, the loan balance will increase to $10,500 after a year. However, inflation reduced the value of each dollar the borrower owes. The easiest way to find the real interest rate, meaning the real cost of the loan, is to subtract the inflation rate (3%) from the interest rate (5%), meaning the real interest rate is 2%.

Takeaway

A real interest rate is like a test graded on a curve…

If you take a test that the teacher plans to grade on a curve, the results you get might have a very different impact on your grade than they seem to at first. For example, you may get 50 out of 100 before the curve; but, after the curve, have the exam count as the equivalent of 80 out of 100.

A real interest rate is similar. A rate may seem high but have a much smaller effect on the purchasing power of the funds you pay back to the lender — because inflation has decreased the value of each dollar you pay back to your lender.

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What is a real interest rate?

A real interest rate is an interest rate that describes the true cost of borrowing money by accounting for the impact of inflation on the changing value of the money the borrower must repay to the lender.

When someone borrows money from a lender, that person usually doesn’t get to borrow that money for free. Typically, lenders charge fees and/or interest on the loan. Lenders typically quote interest rates as a percentage of the loan amount per year, though the lenders usually add interest charges more often than once per year.

Inflation is a phenomenon that causes money to lose value over time. Like interest, inflation is typically quoted as a percentage. If inflation for a year is 5%, then something that cost $100 at the start of the year will now cost $105.

When borrowers pay back loans, they repay the loans based on the number of dollars that they borrowed, rather than the actual value of those dollars. If someone borrows $1,000 at the start of the year using a no-interest loan, then pays back the $1,000 at the end of the year, they actually give the lender less value than they received, assuming the inflation rate is above zero.

Charging interest is one way that lenders compensate for the effects of inflation. If the lender charges a higher interest rate than the inflation rate, the lender will collect more value than it lent out. If they charge an interest rate below the inflation rate, they will receive less value, even though it receives more dollars. Those dollars would have less spending power than the amount originally lent.

Calculating the real interest rate, by subtracting the inflation rate from the nominal interest rate, provides a more accurate view of whether the borrower will repay the lender with money worth more or less than the amount that they borrowed.

What is the difference between nominal and real interest rate?

Nominal interest rates do not account for inflation. Real interest rates do account for inflation.

Nominal interest rates are the interest rates quoted by lenders or banks for loans or savings products. For example, if you get a mortgage with an interest rate of 3.5%, then 3.5% is the nominal interest rate.

Real interest rates are nominal interest rates adjusted for the effects of inflation. The easiest way to find the real interest rate is to subtract the rate of inflation from the nominal interest rate of a loan. If inflation is 2%, then the real interest rate for the above mortgage is 1.5%.

Nominal interest rates reflect the interest charged in the number of dollars while real interest rates reflect the interest charged in terms of actual purchasing power.

Which factors determine the real interest rate?

Two factors, nominal interest rates and the rate of inflation, determine real interest rates.

Interest rates vary widely for different types of loans and depend on many factors such as the borrower’s credit score and the collateral, if any, they provide. However, one thing that plays a major role in determining rates for all types of loans is the federal funds rate.

The federal funds rate is a benchmark interest rate that many lenders use to determine the rates they offer on savings accounts and certificates of deposits and the rates they charge on loans. The Federal Reserve (the United States’s central bank) sets the federal funds rate by buying and selling US Treasuries. It sets rate targets based on the economy and how it wants to react to it. For example, the Fed may increase rates to fight off high inflation or decrease rates to boost a faltering economy.

Inflation is complicated, and many factors contribute to rising and falling rates of inflation.

One type of inflation, demand-pull inflation occurs when demand rises faster than an economy’s productivity, driving up prices. Cost-push inflation happens when wages or other production inputs increase in price. Some other factors, such as government stimulus through printing money, can also increase inflation.

Combined, the nominal interest rate for a loan, which is partially determined by the federal funds rate, and inflation, determine real interest rates for loans.

How to calculate the real interest rate?

The real interest rate formula is:

Nominal interest rate – Inflation rate = Real interest rate

For example, if you have a loan that charges 5% interest, and inflation is 2%, the real interest rate of that loan is:

5% – 2% = 3%

When it comes to calculating real interest rates on things like bonds or savings accounts, people often want to subtract out the taxes that they must pay on the income they receive. The formula for this is:

Nominal interest rate – inflation rate – (1 – tax rate) = Real interest rate after tax

How to find the real interest rate?

Finding the real interest rate requires two pieces of information: the nominal interest rate and the current rate of inflation.

To find the interest rate for a loan or savings account, the best thing to do is to check the paperwork that came with the loan or account. It should outline the interest rate. You can also contact your bank or lender to ask.

The Bureau of Labor Statistics regularly publishes the Consumer Price Index, which it uses to track inflation, so you can find data on inflation rates using the Bureau’s website.

Once you have both of those pieces of information, you can find the real interest rate.

Can the real interest rate be negative?

Yes, the real interest rate for a loan can be negative. If the nominal rate is lower than the rate of inflation, the real interest rate for the loan will be less than zero percent.

When this happens, the lender receives money with a lower total spending power than it lent out, even once the borrower completely pays back their loan.

What is the expected rate of inflation?

The expected rate of inflation can change from year to year and from month to month. A huge variety of factors play into the changing value of money, so it can be hard to predict what the inflation rate will be at any point in time.

The Federal Reserve sets an inflation target based on its goal for managing the economy: maintaining stable growth. Currently, the Fed’s long-term inflation rate target is 2% per year.

What is the effect of inflation on real interest rates?

Typically, high levels of inflation reduce real interest rates. One of the reasons that lenders charge interest on loans is to compensate for the effects of inflation, ensuring that borrowers pay back money that has equal or higher spending power relative to the money that they borrowed.

Typically, as inflation rises, nominal interest rates also increase. That helps keep real interest rates similar to previous real interest rates even as inflation increases. However, the ratio of increase in nominal rates and the inflation rate tends to be less than one-to-one. For every 1% increase in the inflation rate, nominal interest rates usually increase by slightly less than 1%, meaning higher inflation correlates to lower real interest rates.

What is the current real interest rate?

The real interest rate depends on the specific loan or security that you are analyzing. To find the real interest rate for a loan or a security, you must subtract the inflation rate from its nominal rate.

In January of 2020, the annual CPI inflation rate in the United States was 2.5%, so to find the real interest rate for a loan or the real rate of return that you earn on a savings account, subtract 2.5% from the nominal rate.

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