The nominal interest rate is the simple interest charged on a loan or paid on a deposit. Real interest is nominal interest after taking inflation’s effects into account. Economists, as well as lenders and borrowers, calculate real interest to get a more accurate picture of the profit on a loan or deposit after accounting for changes in purchasing power. Real interest is especially important when dealing with long-term deposits and loans, because inflation’s effects are compounded over time.
A qualified financial advisor can help you get a precise picture of your finances and guide you in making smart decisions with your money.
Nominal Interest Rate Basics
Interest is the cost to borrow money, as well as the profit when lending money. The interest rate is a prime consideration when evaluating a credit card offer, a mortgage, an auto loan, a savings account or a certificate of deposit.
The nominal interest rate is the most basic way to state the amount of interest applied to a deposit or loan. The nominal interest rate may also be called the simple interest rate. It is used with uncomplicated loans when the interest rate is applied to the principle for the term of the loan. For example, with a nominal interest rate of 8%, a one-year loan of $1,000 will cost $80. At the end of the year, the borrower pays back $1,080.
Nominal interest is also sometimes called the advertised rate or the stated interest rate. That is because financial institutions may use it in promotions for loans or deposits or in loan documents.
Not all advertisements refer to nominal interest rates, however. Financial institutions such as banks and credit unions, also often state annual percentage yield (APY) for deposits and annual percentage rate (APR) for loans. These interest rates include the effects of other factors, such as compound interest and fees that come into play with more complex transactions such as mortgage loans. The APR and APY will generally be higher than the nominal interest rate.
Real Interest Rate Basics
Economists often employ real interest rates rather than nominal interest rates. Real interest rates account for the effects of inflation. Inflation reduces the purchasing power of future dollars. Including the effects of inflation gives a more accurate picture of the real cost of a loan for a borrower. Depositors can also use real interest to get a clearer idea of the return on an interest-bearing investment.
To approximate the real interest rate, subtract the inflation rate from the nominal interest rate. For example, if the inflation rate is 5%, on a one-year loan of $1,000 with an 8% nominal interest rate the real interest rate would be 8% minus 5% or 3%. The real interest rate will usually be lower than then nominal interest rate.
Other Interest Rates
Nominal interest rates and real interest rates are just two of several types of interest rates that may come up when evaluating an investment or a loan. Another useful interest rate is the effective interest rate or effective annual rate, which includes the effects of compounding.
Many loans and deposits calculate interest more often than once a year, such as semiannually, quarterly or daily. This is called compounding, and when a loan or deposit employs compounding, the interest earns interest. Compounding can have a meaningful effect on the cost of a loan or return on an investment over time.
Bottom Line
The nominal interest rate is a simple way of expressing the cost of a loan or the return on a deposit. The real interest rate accounts for the effect of inflation on the purchasing power of dollars used to repay a loan or as profit on an investment. Neither the nominal interest rate nor the real interest rate will always fully account for the actual cost of many loans, including credit cards, lines of credit, mortgages and auto loans. Other factors, including fees and compounding of interest, can also significantly increase the cost of loans, especially over longer periods of time.
Financial Planning Tips
- A financial advisor can help you to better understand how different types of interest rates can impact your financial situation as an investor and a borrower. Finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to figure out how much your savings could grow, SmartAsset’s savings calculator can help you get an estimate. This free online tool uses the annual percentage yield on your savings account to calculate what your savings account balance could be after a selected time period. This tool can also help you account for making regular extra contributions to your savings account.
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