The nominal interest rate is the simple interest received on a loan or paid on a deposit. Real interest is nominal interest after taking into account the effects of inflation. Economists, as well as lenders and borrowers, calculate real interest to get a more accurate picture of profit on a loan or deposit after accounting for changes in purchasing power. Real interest is particularly important when it comes to deposits and long-term loans, because the effects of inflation worsen over time.
A qualified Financial Advisor can help you get an accurate picture of your finances and guide you in making informed decisions with your money.
Basic principles of the nominal interest rate
Interest is the cost to borrow money, plus the profit when lending money. The interest rate is a primary consideration when evaluating a credit card offer, mortgage, car loan, savings account, or certificate of deposit.
The nominal interest rate is the simplest way to indicate the amount of interest applied to a deposit or loan. The nominal interest rate can also be referred to as the simple interest rate. It is used with simple loans when the interest rate is applied in principle for the term of the loan. For example, with a nominal interest rate of 8%, a loan of $1,000 for one year will cost $80. At the end of the year, the borrower repays $1,080.
The nominal interest is also sometimes referred to as the advertised rate or the stated interest rate. Indeed, financial institutions can use it in loan or deposit promotions or in loan documents.
However, not all advertisements refer to nominal interest rates. Financial institutions such as banks and credit unions also often declare annual percentage yield (APY) for deposits and annual percentage rate of charge (APR) for loans. These interest rates include the effects of other factors, such as compound interest and fees that come into play in more complex transactions such as mortgages. The APR and APY will generally be higher than the nominal interest rate.
Real Interest Rate Basics
Economists often use real interest rates rather than nominal interest rates. Real interest rates take into account the effects of inflation. Inflation reduces the purchasing power of future dollars. Including the effects of inflation gives a more accurate picture of the true cost of a loan to a borrower. Depositors can also use actual interest to get a better idea of the performance of 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 a nominal interest rate of 8%, the actual interest rate would be 8% minus 5% or 3%. The real interest rate will generally be lower than the nominal interest rate.
Other interest rates
Nominal interest rates and real interest rates are just two of the several types of interest rates that may arise when evaluating an investment or a loan. Another useful rate of interest is the effective interest rate or effective annual rate, which includes the effects of composition.
Many loans and deposits calculate interest more than once a year, such as semi-annually, quarterly or daily. This is called compounding, and when a loan or deposit uses compounding, the interest earns interest. Capitalization can have a significant effect on the cost of a loan or the return on an investment over time.
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 takes into account the effect of inflation on the purchasing power of dollars used to repay a loan or as a profit on an investment. Neither the nominal interest rate nor the actual interest rate will always fully represent the true cost of many loans, including credit cards, lines of credit, mortgages and auto loans. Other factors, including fees and compound interest, can also significantly increase the cost of loans, especially over long periods.
Financial Planning Tips
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