What is the Real Interest Rate?

Real Interest Rate Formula

It can easily be calculated by subtracting the actual or expected inflation rate from the rate of interest quoted for any saving or investment, also known as the nominal interest rateNominal Interest RateNominal Interest rate refers to the interest rate without the adjustment of inflation. It is a short term interest rate which is used by the central banks to issue loans.read more.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Real Interest Rate (wallstreetmojo.com)

It helps bring the fact in perspective that investment should first be evaluated for whether it would help retain the purchasing power of initial investment before one even begins to think of actual profits.

Taxes and inflation need to be accounted for to calculate the real returns on any investment and an understanding of this concept is the first step in that direction.

How to Calculate Real Interest Rate?

If you made a fixed deposit of $10,000 with an annual interest rate of 3% but the rate of inflation for that year is 3%, the calculation of the real interest rate would be like this.

Solution-

  • Nominal Interest Rate =3%Actual or anticipated rate of inflation = 3%

Real Interest Rate = Nominal Interest Rate – Actual or Anticipated Rate of Inflation

Therefore,

  • =3%  – 3% =0%

In our example, it turns out to be 0% which means that the purchasing power of the investment stayed at the same level without experiencing any real change in either direction.

If, in the same example, the nominal interest rate was 5% and the inflation rate was the same at 3%, it would result in a 2% real interest rate calculationReal Interest Rate CalculationThe Real Interest Rate formula calculates the rate of interest after excluding the impact of inflation. It helps measure inflation-adjusted return on investments on financial security or a loan or deposits. Real interest rate formula = normal rate of interest - inflation (actual or expected) read more indicating inflation-adjusted returns. This essentially means the purchasing power of investment went up by 2% in that year.

source – gulfnews.com

Taking the basic idea one step ahead, this interest rate is useful in understanding how an investment works and if the returns could be aligned with the goals. Based on an idea of how much you might earn on a specific investment, viable alternatives can also be explored to achieve the investment objective. For instance, if you are earning 3% annually in a regular savings account, it might translate into a 1% decline in purchasing power if the inflation rate for that year is 4%. 

This is why even if the rate of inflationRate Of InflationThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100.read more might not appear like an important factor to consider, it can significantly impact your investments.

Difference Between Nominal and Real Interest Rate

  • The nominal interest rate is the one quoted for any deposit or investment, which is simply the percentage of the original amount earned in the form of interest in a specific period. The nominal interest rate does not consider any factor that might affect the rate of interest or returns on an investment, including inflation, in that sense. It is not very helpful in getting an idea of actual returns.On the other hand, the real rate takes into account inflation. It provides a means to calculate inflation-adjusted returns on the simplest deposits or investments in a bond or even a regular loan. Utilizing the nominal interest rate, one can deduct the actual or anticipated inflation rate to arrive at the real rate for that investment.

Real Interest Rate and CPI

The rate of inflation is calculated on a yearly or monthly basis, and it forms an important economic indicator apart from impacting national and personal financesPersonal FinancesPersonal Financing is a way of saving, investing, and growing an individual’s money. It can be for an individual or a family as a whole and requires some level of financial literacy such as tax laws, investment opportunities, etc.read more. Consumer Price Index (CPICPIThe Consumer Price Index (CPI) is a measure of the average price of a basket of regularly used consumer commodities compared to a base year. The CPI for the base year is 100, and this is the benchmark  point.read more) tracks how inflation impacts the prices of consumer goods in the retail sector. This is usually considered the benchmark for measuring inflation and is widely used for making calculations where inflation is taken into account.

Since price rise impacts economic activity more directly than most other factors, governments release figures for the anticipated inflation rate for the coming months and years as well. This is often described as a range for want of exactness, and accurate figures can only be obtained for years passed. Nevertheless, despite being approximations, these anticipated figures hold a great deal of relevance when making estimates for the economy as a whole.

CPI figures come in handy for calculating this rate and help provide a reliable approximation of what one might earn on an investment. Moreover, equipped with the understanding of inflation-adjusted interest rates, one can choose suitable investment avenues and avoid going along with options where the inflation rate might exceed the nominal interest rate, resulting in negative RIR, as we have already discussed.

Relevance and Use

  • It offers a sneak peek into this elegant idea of purchasing power at work by considering the impact of inflation on the returns of any investment.Purchasing power and inflation are two interlinked concepts that come into focus here and play a key role in determining the direction of any economy and the state of personal finances.It shows the extent of the increase or decline in purchasing power. The rise in prices based on market factors leads to inflation and results in a proportional decline in purchasing power of money, so any fixed amount doesn’t buy an equal amount of goods at different points of time.Purchasing power is in a constant state of flux, and inflation is the deciding factor to control which governments create policies to stabilize the economy and help afford its people the worth of their money.

Conclusion

It helps assess and understand how inflation directly impacts any returns on investment and becomes a guiding factor for choosing the right investment avenue. This is also the first step to understanding how macroeconomic forces shape individual money choices and results, thus laying a foundation for making more informed choices by individuals and groups.

This has been a guide to real interest rates and their definition. Here we discuss how to calculate Real Interest rates using its formula and practical examples. You may learn more about macroeconomics from the following articles –

  • Explanation of Put-Call Parity FormulaNominal vs Real Interest RateBank Rate vs Repo Rate