When money is borrowed from a bank, it is usually returned to the bank with a little extra amount in addition to the principal borrowed amount. This extra amount of money paid to the bank is called interest. The amount of money to be paid as interest depends on the interest rates fixed by banks.
Nominal vs Real Interest Rate
The main difference between nominal and real interest rates is that while nominal interests remain stable, the real interest rates are bound to change over time, meaning it is unstable. Nominal interest rates are fixed given the previous rate given, while real interest rates are freshly affected by the present situation.
The nominal interest rate is fixed at the time of disposal of money to the borrower by the lender. It is the rate at which money is being repaid to the bank. It is decided at the time of transaction and does not change over time. This is because it does not take money or economic inflation into account.
The real interest rate is the actual interest rate at which a borrower pays back money to the bank instead of the accounting factors like inflation that change the rate of interest to be paid. This rate of interest hence is a more accurate form of repayment to the banks as the rate is adjusted in case of inflation.
Comparison Table Between Nominal and Real Interest Rate
| Parameters of Comparison | Nominal Interest Rate | Real Interest Rate |
| Also Called | The other name for the nominal interest rate is also the coupon rate. | The real interest rate is also called an actual interest rate. |
| Inflation | The nominal interest rate is fixed without the influence of inflation. | The rate is real interest is fixed with levels of inflation in mind. |
| Amount | Usually, the interest is high in nominal interest rate. | Usually, the interest is low in real interest rate. |
| Stability | Stability is a feature of the nominal interest rate. | Flexibility is a feature of the real interest rate. |
| Adjustment | The nominal interest rate can never be a negative measure. | The real interest rate can be a negative measure if certain conditions prevail. |
What is Nominal Interest Rate?
Nominal interest rate is the rate of interest decided during the acquiring of a loan from a bank. It is decided at the time of issue of the loan and remains steady through till the recovery of the loan. Thus nominal interest rate is a predefined rate of interest on a particular sum of money issued by the bank to a borrower.
The nominal interest rate is made with consideration of demand and supply chains and inflation of the last financial year. It does take into account the inflation changes during the term of the loan. The market is a fluctuating entity, and inflation rates change from time to time. And hence nominal interest rates are also not an accurate rare of interest.
Usually, only if the nominal interest rate is accounted for then the borrower has to repay a larger amount of sum to the bank as inflation reduces the rate of interest on any amount. Thus with the nominal interest rate, you can be sure of the minimum payment that you have to pay back to the bank as the rates of interest do not change.
Nominal interest rates depend upon a lot of factors like risk rate, supply and demand chain, and other factors that affect the money market and the bank itself. Usually, all rates are low when there is ample money in circulation and with the bank, and this can be known by keeping a look at the bank’s previous three or five years rate sheet.
What is Real Interest Rate?
Interest rates and inflation are set by central banks in a country at a specific level where it is considered to be a stable macroeconomic scenario. So, inflation is considered as one of the major economic indicators which indicate the stability of the country’s economy. It is the central bank’s responsibility to increase or decrease the interest rates based on their economy.
Inflation is a major determinant of the general price level of goods and services in an economy and is determined by monetary authorities through controlling the money supply. Inflation represents a loss of real value from the medium of exchange and all nominal assets, a loss that increases the purchasing power of money – a phenomenon that a price index measures.
Thus when inflation occurs, the rate of interest must go down as most things become cheaper. Thus with the real interest rate, you have to pay the correct amount of interest back to by the value of goods in the market.
Thus although unstable, the real interest rate is a more accurate description of the market value of goods and the amount needed to be returned by you for the amount lent but for a bank.
Main Differences Between Nominal and Real Interest Rate
- The nominal interest rate is usually stable over time and adjusted only at the end of the loan, while the real interest rate, due to its flexibility, changes by the market inflation.
- Nominal interest rates can never be of a negative value, while real interest rates can become a negative value if inflation occurs in the market, which makes the prices go much below normal.
- Nominal interest rate is not an accurate marker of the market price of goods and services, whereas real interest rate is an accurate market price marker.
- Nominal interest rate is made without taking inflation into account, whereas real interest rates are determined keeping inflation in mind.
- The nominal interest rate usually makes the borrower pay a larger sum of money than the real interest rate to repay the same amount of loan.
Conclusion
The nominal rate is just the stated interest rate. As an example, let us consider that a bank offers a 7.5% nominal interest rate for a sum of 100$. It means at this rate, when you deposit $100, then in one year, you will have to pay back the bank $107.5. In contrast, the real interest rate considers inflation. Following the same example, if we have a nominal interest rate of 7.5% and a rate of inflation for that year was 2%, then the real interest rate is 7.5 -3= 4.5%
If you are looking for ways to reduce your debt, then you may want to know more about real and nominal interest rates. The nominal rate is the rate at which the lender lends you money for your loan. The difference between the two must be known to make the right choice of banks and time to apply for large loans for better finance.
References
- https://www.journals.uchicago.edu/doi/abs/10.1086/261132
- https://www.jstor.org/stable/2077969