- The real interest rate accounts for the impact of inflation on the cost of loans and returns on savings.
- It is calculated by subtracting the inflation rate from the nominal interest rate.
- If inflation levels exceed the nominal rate on a savings account, the dollars you put in will lose buying power.
Interest is the amount of money that a lender charges a borrower or a saver earns on deposits and investments. But there are several types of interest rates, each of which measures the costs and returns differently, including the real interest rate.
What is a real interest rate?
The real interest rate indicates the actual borrowing cost or return on savings after taking into account the impact of inflation. This provides consumers with a fuller picture of how interest rates will affect their finances over the long term.
Since the impact of inflation can be significant, real interest rates serve as a useful reference point for borrowers and savers. Higher real interest rates are generally good for savers but bad for borrowers. On the flip side, lower real interest rates tend to benefit borrowers and are detrimental to savers.
Why it’s important to understand real interest rates
Real interest rates affect your purchasing power. As a simple example, let’s say you’re considering purchasing a product that costs $ 103, but you only have $ 100. You decide to put that money into an account that pays
of 3% over one year, so at the end of the year you’ll have $ 103. However, inflation was 5%, so at the end of the year, the product costs $ 105. With that price increase, you wouldn’t have enough to buy it because when making the savings plan you only considered the nominal and not the real interest rate. The value of your money actually decreased during the period you had it in the account.
“If a real interest rate is positive, it implies you will have more purchasing power in the future if you start saving today,” explains Toni Nasr, a chartered financial analyst (CFA) with Investing in the Web. “In contrast, if the real interest rate is negative, saving today to buy the same product later won’t be feasible, as your purchasing power will diminish.”
The possibility of negative real interest rates in an inflationary environment leads shoppers to prefer buying goods today instead of waiting to make the purchase. This is commonly referred to as the time-preference theory of interest.
You can benefit from looking beyond nominal interest rates to find the real interest rate when making investment and borrowing decisions. At the very least, it will let you know if a potential opportunity will end up eroding your purchasing power.
You can calculate the real interest rate by subtracting the rate of inflation from the nominal interest rate. Here’s the formula:
Real interest rate = nominal interest rate – rate of inflation (actual or expected)
The bottom line
Interest rates play a key role in consumers’ financial lives. But with the various ways that interest rates are calculated and expressed, it’s easy to get confused about what it is they’re telling you.
When shopping for a loan or a savings account, you’ll often see nominal interest rates advertised. They reflect you the amount of interest paid or earned before taking inflation into account. Real interest rates gives a more complete picture as they’re adjusted to take into consideration the changes in the buying power of the money borrowed or deposited.
So when it comes to interest rates, it’s important to remember that what you see is not necessarily what you get. Understanding which interest rate you’re looking at is key to making the most of your money.