Distinction Between Nominal and Real Interest Rates
The interest rate that is specified in a loan or deposit agreement is known as the nominal interest rate. It is the interest rate quoted to both borrowers and lenders and is used to determine how much interest will be paid on loan or earned on a deposit. The nominal interest rate is presented as a percentage of the loan or deposit’s principal. The nominal interest rate is adjusted for inflation to get the real interest rate. It accounts for changes in the purchasing power of money over time and indicates the actual cost of borrowing or the genuine return on a deposit. Some significant differences between nominal and real interest rates are listed below:
- Real interest rates are determined based on the nominal interest rate and the inflation rate, whereas nominal interest rates are indicated in a loan or deposit agreement.
- Real interest rates indicate the genuine cost of borrowing or the actual return on a deposit. In contrast, nominal interest rates are used to compute interest payments on loans or the interest collected on deposits.
- Real interest rates account for inflation, but nominal interest rates do not consider how inflation affects the purchasing power of money.
- When inflation rises, nominal interest rates are frequently higher than real interest rates. In contrast, when inflation is negative, nominal interest rates are frequently lower than real interest rates.
- Purchasing power is related to the nominal and real interest rates because it is affected by inflation, which can reduce the value of money over time. When the inflation rate is higher than the nominal interest rate, the real interest rate will be negative, which means that the purchasing power of the money you receive from the loan or investment will be less than the purchasing power of the money you paid out. When the inflation rate is lower than the nominal interest rate, the real interest rate will be positive, which means that the purchasing power of the money you receive will be greater than the purchasing power of the money you paid out.
Nominal vs Real Interest Rates
The portion of a loan that is charged to the borrower is called an interest rate, and it is often stated as an annual percentage. Lenders utilize interest rates to cover the risk they assume when making loans, and they can also be used to help keep inflation under control.