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What Is the Difference Between Nominal Interest Rate and Real Interest Rate?

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  • Written By: Terry Masters
  • Edited By: Shereen Skola
  • Last Modified Date: 20 July 2014
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    Conjecture Corporation
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The difference between a nominal interest rate and real interest rate is an analysis of profitability for the lender charging the interest. A nominal interest rate is the stated rate on a loan. It is the amount of interest the borrower pays until the loan is retired. The real interest rate is calculated by subtracting the expected rate of inflation from the nominal interest rate. Nominal interest rates are static, while real rates are fluid and dependent on an outside factor.

Interest is the cost of borrowing money. From the lender's perspective, it is the amount of profit he receives from allowing a borrower to use his money. Profit is a fluid concept, however. What may be considered profitable today might be unprofitable tomorrow, under a different set of circumstances.

Lenders set an interest rate when the loan is made. That rate is called the nominal interest rate, and it reflects a fixed rate of return over the life of the loan. The amount of interest may not be as valuable to the lender in the future, however, if the cost of living becomes more expensive. If the lender receives $100 US Dollars (USD) today and can buy 100 hamburgers but in the future can only buy 75 hamburgers for the same amount of money, that money has become less valuable. In this scenario, the fact that someone else is holding the lender's money has suddenly become less profitable.

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This change in the value of money is the rate of inflation. Inflation is often measured by the rise and fall of an economic index, such as the Consumer Price Index (CPI) in the U.S. that tracks the prices of consumer goods against a baseline. The basic difference between a nominal interest rate and real interest rate is that a real interest rate controls for inflation. In practice, the expected rate of inflation is subtracted from the nominal interest rate in future years to determine the actual profitability of the loan at that time.

For example, a five year loan has a 10 percent nominal rate, but in the fourth year inflation is expected to rise by three percent. In the year that the rate of inflation changes, the real interest rate changes. The real interest rate in that year would be seven percent, so the loan would be less profitable to the lender. In this example, the difference between the nominal interest rate and real interest rate in year four is three percent.

Estimating future inflation is speculative. There is no sure way to determine what the inflation rate will be in any future year. Lenders must charge enough interest to ensure the loan will remain profitable, against any possible change in inflation. Once the inflation rate equals or exceeds the nominal interest rate on the loan, there is no longer a profit being made on the transaction. This is why some loans are tied to the CPI and set at a variable rate that is the CPI rate plus a certain percentage.

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