Real Interest Rate
A nominal interest rate is used as a basis for calculation and does not include the amount added by inflation. Conversely, it shows the true borrowing cost and the real investment yield.
If you want to make informed financial decisions, you need to understand how it’s calculated and how it affects your investments. It reflects the actual purchasing power of the money involved and helps investors and borrowers gauge the real cost of loans and the actual returns on investments.
Calculating Real Interest Rate
To find out the real interest rate, you need to adjust the nominal interest rate to account for inflation. First, identify the Nominal Interest Rate ― the official interest rate on loans or investments. It can be found in loan agreements, bond yields, or savings account rates. Then, determine the Inflation Rate. Inflation affects the prevailing level of costs for products and services. If it’s high, the prices increase and the value of money is lower. You can look up the current inflation rate in economic reports or indexes like the Consumer Price Index (CPI). After that, use a simple formula: Real Interest Rate = Nominal Interest Rate − Inflation Rate.
How Does Real Interest Rate Affect Investments
The real interest rate affects the actual return on investment (ROI) and shapes investor decisions in several ways.
- The real interest rate adjusts for inflation. It shows the real changes in purchasing power. For example, if a bond has a nominal interest rate of 10% and inflation is 3%, the real interest rate is approximately 7%. This 7% represents the true increase in purchasing power, which is a more accurate representation of potential investment yield.
- Investors use the real interest rate to compare different investment opportunities. An investment with a higher real interest rate is more attractive because it offers a better inflation-adjusted return.
- The real interest rate serves to gauge the risk-reward balance. Higher real rates indicate better returns relative to inflation, making riskier investments potentially more worthwhile.
- For bonds and fixed-income securities, higher real interest rates generally mean higher real returns, making these investments more appealing. When real interest rates drop, the real return on these investments goes down. This pushes investors to search for better opportunities elsewhere, such as in stocks or real estate.
- Central banks, like the Federal Reserve, control the economy by influencing nominal interest rates, which helps manage inflation. Even slight changes in nominal rates affect real interest rates, which completely changes investment strategies.
- When real interest rates are high, more people consider creating savings accounts. It leads to potentially lower consumption and investment in riskier assets. When real rates are low, borrowing and investing in higher-risk assets can become more attractive.
- For long-term investments like retirement savings, the real interest rate ensures that the growth of the investment outpaces inflation. This, in turn, keeps the purchasing power at roughly the same level for a while.
- Understanding current real interest rates helps diversify a portfolio to balance between fixed-income securities and equities. You should aim for a mix that provides growth while managing inflation risk.