Interest rates are used everywhere in the finance and investment industries, from personal loans and mortgages to bond rates and savings accounts. Almost every type of financial product has an interest rate associated with it. Nominal rates, real rates, and effective rates are types of interest rates, but they are different from one another. Understanding these differences could help you make better financial decisions.
Nominal Interest Rate
The nominal interest rate is the simplest rate to understand; it’s the stated interest rate of the financial product or loan. If a bank says that a loan has 7% interest, the 7% is the nominal interest rate. If a savings account states that it pays 1% interest, then the 1% is the nominal interest rate. The nominal interest is simply the expected amount of interest to be earned or paid on a financial product. There is no formula to calculate a nominal interest rate; the rate is chosen by the financial institution. Using the example above, if you borrow a $1,000 loan at 7% nominal interest, you’ll also need to pay $70 of loan interest to the bank.
Real Interest Rate
The real interest rate is also straightforward, but it’s a little more complex than a stated nominal interest rate. The real interest rate takes the effects of inflation into account. Your purchasing power goes down over time because prices for goods and services rise. The real interest rate is the actual interest rate your earn or pay after taking the effects of inflation into account. The Fisher effect is the relationship between nominal interest rates, real interest rates, and inflation. The simple way to calculate the real interest rate is to take the nominal interest rate and subtract the inflation rate. For example, assume an investment offers to pay you 8% interest. That’s the nominal rate. Upon some research, you find that the inflation rate for the year is 2%. That means the real amount of interest you will earn is 6% (8% – 2%).
Effective Interest Rate
The effective interest rate is a way to figure out the total amount of money earned or paid, because it includes the effects of compound interest. Compounding is the process of an investment’s profits generating more profits themselves. For example, assume a $1,000 investment pays 10% interest, compounded twice a year. The investment starts at $1,000; six months later, it receives half of the 10% interest, or 5%, so it’s worth $1,050. Six months later, it receives another 5%, but this time, the 5% is calculated on $1,050 instead of receiving $50, the investment receives $52.50. The total interest received on $1,000 is $102.50, so the effective interest rate is 10.25%. The more times per year an investment is compounded, the more money it will make. For example, an investment that’s compounded once per year ends up being worth less money than an investment that’s compounded four times per year, even if both investments have the same interest rate.While nominal, real, and effective interest rates are all related in some ways, they are different in their applications and results.