What is Real Interest Rate?
Prior to discussing how to calculate real interest rate, let’s define what interest and interest rate is. Interest is the monetary charge for borrowing money while an interest rate is a percentage that you are charged for borrowing money.
Secondly, a real interest rate also known as inflation adjusted interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.
The real interest rate gives investors a better idea of the rate at which their purchasing power increases or decreases.
Why its Important to Understand Inflation Adjusted Interest Rate.
- Real interest rates affect your purchasing power . This is because in this type of interest rate, inflation is considered and we know that inflation decreases the number of goods or services you can purchase.
- If a real interest rate is positive, it implies you will have more purchasing power in the future if you start saving today.
- The possibility of negative real interest rates in an inflationary environment leads shoppers to prefer buying goods today instead of waiting to make the purchase.
- You can benefit from looking beyond nominal interest rates to find the real interest rate when making investment and borrowing decisions.
- If the level of inflation is higher than the nominal interest rate, it’s possible to have a negative real interest rate. Negative real interest rates indicate a loss of purchasing power for the principal.
Formula to Calculate Real Interest Rate.
You cannot find the real interest rate without understanding the nominal interest rate. Nominal interest rates don’t take inflation into account. As a borrower or saver, you’ll often find that nominal interest rates are what banks and lenders advertise.
To calculate the inflated adjusted interest rate, we use the Fisher’s equation.
Inflation is the long term rise in the prices of goods and services caused by the devaluation of currency
Example 1:
Suppose a certain economy’s nominal interest rate was 14% and its inflation rate was 5%. Calculate the real interest rate.
Therefore, the real interest rate is 9%.
Example 2:
If the initial interest rate on a bond was 15% and the projected rate of inflation was 2%. Calculate the real interest rate.
Thus, the real interest rate is 13%
