Rates of interest show how much it costs to borrow money or save it. They are given as a share of the total amount of the loan or investment. They show how much a lender makes when someone takes out a loan or puts money into a savings account. Interest rates can be talked about in real or made-up terms. A real interest rate considers inflation and shows how much it really costs to borrow money and how much the lender or investor makes back. A nominal interest rate, on the other hand, is the interest rate before inflation is considered. Real interest rates show how much money investors can spend, while nominal interest rates show how the market is doing now.

Real Interest Rates

A "real" interest rate takes inflation into account. This means that it considers inflation and tells you what the real interest rate on a bond or loan is. This interest rate indicates the expected return after accounting for inflation. This rate is considered a good predictor when the real inflation rate is unknown or not desired.

Investors may calculate the actual rate of return by comparing the yield on a Treasury bond to work on a Treasury Inflation-Protected Security (TIPS) with the same maturity date. This shows how much the economy is expected to go up in price. You can also figure out the real interest rate on a loan or investment.

Nominal Interest Rates

It's easy to understand the nominal interest rate. It is the rate that you will hear about from banks, companies that sell bonds and loans, and companies that sell particular investments. It's the interest rate paid or earned before inflation is considered. So, if you borrow $100 at a rate of 6%, you can expect to pay $6 in interest before you take inflation into account. The problem with nominal interest rates is that they don't account for inflation.

The nominal interest rates for the short term are set by the central banks. Based on these rates, banks and other businesses decide how much interest to charge their customers. Central banks may keep nominal rates low to get the economy going. People tend to take on more debt and spend more when nominal rates are low.

Special Considerations

We have previously gone through some of the most important distinctions that may be made among real and nominal interest rates. Below, we will discuss additional points to keep in mind regarding each option.

What They Stand For

One of the biggest differences between real and nominal interest rates is how much buying power you have compared to how much interest you pay or get. Investors can determine how much they can buy by looking at real interest rates. So, when people put money into an investment or savings account, they know how much they can make. When inflation is high, the value of an investor's money goes down, and when inflation is low, the value of an investor's money goes up.

On the other hand, nominal rates show both how much money costs overall and how the market is doing right now. As was said above, these rates depend on the interest rates set by the central bank, which in the US is the Federal Reserve. These rates tend to be higher when things are going well. But they tend to go down when the economy is bad.

Negative Rates

Since real interest rates take inflation into account, there is a possibility that they may end up in an unfavourable situation. This is often the case when the inflation rate is higher than the nominal rate. So, if the nominal interest rate on your savings account is 1% and inflation is about 2%, your real rate of return is -1%. This is true, unlike nominal rates, which can never be written as a negative number. People who save money in an account with a negative interest rate would have to pay the bank to keep their money. In the same way, people who borrow money from a bank that charges them negative interest rates would have to pay it back.

Are Real Interest Rates Lower Than Nominal Interest Rates?

The majority of the time, nominal interest rates are found to be greater than actual interest rates. This is because real interest rates are calculated after inflation has been factored in. To determine what the real interest rate is, start with the nominal interest rate and deduct the rate of inflation from it. If inflation and nominal interest rates rose simultaneously, this would be affected differently.