Real Interest Rate, Formula, Calculation Example

Real Interest Rate: The nominal interest rate represents the interest paid on a loan or investment. In contrast, the real interest rate indicates the change in purchasing power resulting from an investment or foregone by the borrower.

Financial institutions typically advertise the nominal interest rate. Adjusting this rate for inflation helps assess the change in purchasing power of a specific amount of capital over time.

Real Interest Rate Meaning

A real interest rate is a rate that has been modified to account for inflation, providing an accurate picture of the actual cost of borrowing for a borrower and the real return for a lender or investor.

It signifies the preference for present goods over future goods. To calculate the it for an investment, subtract the inflation rate from the nominal interest rate.

Real Interest Rate Formula

The real interest rate may be estimated by subtracting the actual or predicted inflation rate from the nominal interest rate, which is the rate advertised for saves or investments. This formula helps assess the real worth of cash after accounting for inflation.

In other words, you may calculate the it by removing the inflation rate from the nominal interest rate using the formula:

Real Interest Rate=Nominal Interest Rate−Actual or Anticipated Rate of Inflation

Or

R = [(1+ (r)/(1+ (i)] – 1

Where:

R = Real interest rate

r = Nominal interest rate

i = Inflation

How to Calculate Real Interest Rate

Here's a breakdown of how to calculate it using two different methods:

Method 1:

Begin by identifying the nominal interest rate, typically an annual rate associated with a specific investment.

Next, determine the annualized inflation rate, often available from government databases.

Calculate the real interest rate by dividing one plus the nominal interest rate by one plus the inflation rate during the period using this formula:

Real Interest Rate = [(1 + Nominal Interest Rate) / (1 + Inflation Rate)] – 1

Method 2 (based on the Fisher equation):

Alternatively, you can find the it by subtracting the inflation rate during the period from the nominal interest rate as shown below:

Real Interest Rate = Nominal Interest Rate - Inflation Rate

These two methods provide different ways to calculate the interest rate, offering flexibility in understanding its impact on investments and finances.

Looking for the Best Commerce Coaching?

Enroll Now in PW Commerce Batches !

Real Interest Rate Example

Suppose an investor puts $10,000 in a fixed account with a yearly interest rate of 3%, and throughout that year, the inflation rate is likewise 3%. The computation of the interest rate might appear like this:

Solution:

Nominal Interest Rate = 3%

Actual or expected inflation rate = 3%

Real Interest Rate = Nominal Interest Rate - Actual or Anticipated Rate of Inflation

Therefore,

Real Interest Rate = 3% - 3% = 0%

In this scenario, the real interest rate is found to be 0%, indicating that the purchasing power of the investment remains unchanged, with no real gain or loss.

Real Interest Rate VS Nominal Interest Rate

Uses of Real Interest Rate

• Its data provides insights into the impact of inflation on investment returns, demonstrating the concept of purchasing power in action.
• It highlights the interconnectedness of purchasing power and inflation, which are crucial factors shaping the economy and individual financial situations.
• It reveal changes in purchasing power, showing how market-driven price increases (inflation) result in a proportional decline in the value of money. This means a fixed amount of money buys different amounts of goods over time.
• Purchasing power is continually changing, and inflation plays a pivotal role. Governments formulate policies to stabilize the economy, ensuring people's money retains its value amidst fluctuating purchasing power.

Real Interest Rate FAQs

Q1: What is the nominal interest rate formula?

A1: Nominal Interest Rate = Real/Actual Interest Rate + Inflation Rate

Q2: What is nominal interest and real interest?

A2: Nominal interest is the stated interest rate, while real interest accounts for inflation, indicating the actual purchasing power change.

Q3: What is the real interest rate of a loan?

A3: The actual interest rate of a loan is the nominal interest rate minus the inflation rate, indicating the loan's actual cost considering inflation.

Q4: What is a real rate of return?

A4: Real rate of return measures the actual gain or loss on an investment after considering inflation, providing a true picture of investment performance.

Q5: Can interest rate be negative?

A5: Yes, a negative interest rate occurs when the nominal interest rate is lower than the inflation rate, resulting in a decrease in purchasing power.