What is the Nominal Interest Rate and Real Interest Rate?
The nominal interest rate is the price of money that investors and borrowers pay or receive without taking inflation into account. Nominal interest rates are usually advertised by financial institutions, such as banks and credit unions, and can be found on advertisements for mortgage loans, deposit accounts and other types of bank products and services.
Nominal interest rates can also be used by the Federal Reserve to set benchmark rates, which influence the prices of other financial products and services. For example, the Fed funds rate is a benchmark rate used by the Federal Reserve to determine the cost of borrowing money at various banks around the country.
In general, nominal interest rates are influenced by supply and demand for money and the economic inflation rate of the previous monetary year. However, the market is a complex, volatile substance that can change in response to unforeseen events or changes in market conditions.
When the economy is strong, nominal interest rates are generally higher than in times of recession or economic distress. As a result, borrowers often pay more for their loans or deposits than they would otherwise have to.
Why Is Nominal Interest Rate Different from Real Interest Rate?
Nominal interest rates are the interest that a borrower or investor pays or receives in a given period of time, such as a year. These rates are typically stated as an annual percentage and may be included in a lender’s advertisement or offered by a financial institution as part of its product offerings.
Lenders often advertise their loan or deposit interest rates to attract new business, as they can profit from these types of transactions by charging more for the same amount of money than they could if they paid less in interest. In addition, lenders must factor in a certain level of expected inflation into their interest rates to maximize the amount of money they can earn.
Real interest rate, on the other hand, refers to the actual interest earned or received by a borrower or investor, adjusted for inflation. This measure of purchasing power is used by economists, lenders and borrowers to make better financial decisions.
Inflation is the increase in the cost of goods and services that occurs over time. This increase in the cost of living reduces the value of money, so it’s important to adjust interest rates for inflation to calculate the real value of a loan or investment.
There are two ways that real interest rates can be calculated: one method is to subtract a particular year’s actual or expected inflation from a nominal rate, and the other is to add an inflation index. The CPIX index, for example, is the most popular method of measuring inflation in the United States.
If you are looking for a financial advisor to help you manage your finances, it’s best to take both the real and nominal interest rates into consideration to get a more accurate picture of your money’s value over time.