What is the difference between a real interest rate and a nominal interest rate?

In our current economic conditions, it is important to understand interest rates.  If you do not understand what the actual cost of borrowing of lending money is, you could be cheating yourself out of profits.  Let’s start by defining nominal interest rates.  The nominal interest rate is the market interest rate before an adjustment for inflation.  Based upon that, you could probably guess what the real interest rate would be.  The real interest rate is the nominal interest rate minus the rate of inflation.  The rate of inflation that you use could be the current rate or your expectation of what the rate will be in the future.  The nominal rate is what you will see when you look at your bank’s website.

Currently, my bank is quoting 3.89% for a 12-year fixed-rate home loan.  According to inflationdata.com, the inflation rate in August 2011 (most recent available data) was 3.77%.  This means that the 12 loan has a nominal interest rate of 3.89% and a real interest rate of 0.12%.  So, if you take out this loan, you it will cost you 0.12%.  As of writing this, the rate on a 6 month CD is 0.23%.  If you convert that to a real interest rate, using the same 3.77% inflation rate, you are paying 3.54% for the privilege of having the bank hold your money.

Next time you are planning out your next investment, take a moment to think about what the real interest rate is.

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