What is the Real Interest Rate?
Real interest rates are the interest rates derived after considering the impact of inflation which is a means of obtaining inflation-adjusted returns of various deposits, loans, and advance and hence it reflects the real cost of funds to the borrower, however not generally used in deriving cost.
Real Interest Rate Formula
It can easily be calculated by subtracting the actual or expected rate of inflation from the rate of interest quoted for any sort of saving or investment which is also known as the nominal interest rate.
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 in order 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% as well, the calculation of Real Interest Rate would be like this.
- Nominal Interest Rate =3%
- Actual or anticipated rate of inflation = 3%
Real Interest Rate = Nominal Interest Rate – Actual or Anticipated Rate of Inflation
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- =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 rate of inflation was the same at 3%, it would result in a 2% real interest rate calculation indicating inflation-adjusted returns. This essentially means the purchasing power of investment went up by 2% in that year.
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Taking the basic idea one step ahead, this interest rate is also useful in understanding how an investment works and if the returns could actually be aligned with the goals. Based on an idea of how much you might actually 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 saving account it might actually translate into a 1% decline in purchasing power if the rate of inflation for that year is 4%.
This is why even if the rate of inflation 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 time period. The nominal interest rate does not take into account any factor which 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.
- The real rate, on the other hand, takes into account inflation and provides a means to calculate inflation-adjusted returns on the simplest of deposits or investments in a bond or even a regular loan. Utilizing the nominal interest rate, one can deduct the actual or anticipated rate of inflation 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 as well as personal finances. Consumer Price Index (CPI) tracks how inflation impacts the prices of consumer goods in the retail sector and this is usually considered as 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 rate of inflation 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. Despite being approximations, these anticipated figures hold a great deal of relevance when making estimates for the economy as a whole.
For calculating this rate as well, CPI figures come in handy and help provide a reliable approximation of what one might actually earn on an investment. Equipped with the understanding of inflation-adjusted interest rates one can choose suitable investment avenues and avoid going along with options where the rate of inflation might exceed the nominal interest rate which would result in negative RIR as we have already discussed.
This would effectively take away the purchasing power of the amount originally invested and by comparison, it would be better to spend the money on consumables instead of investing if the returns don’t keep up with the anticipated rate of inflation.
Relevance and Use
- It offers a sneak peek into this elegant idea of purchasing power at work by taking into account the impact of inflation on returns of any investment.
- Purchasing power and inflation are two interlinked concepts which come into focus here and play a key role in determining the direction of any economy as well as 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 lead to inflation and result in a commensurate decline in purchasing power of money, which is why 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 here, to control which governments create policies with a view to stabilize the economy and help afford its people deserved worth of their money.
It helps assess and understand how the rate of inflation directly impacts any returns on investment and also becomes a guiding factor for choosing the right investment avenue. This is also the first step to understand how macroeconomic forces shape individual money choices and results, thus laying down a foundation to making more informed choices by individuals and groups.
This has been a guide to what is Real Interest Rate and its definition. Here we discuss how to calculate Real Interest Rate using its formula along with practical examples. You may learn more about macroeconomics from the following articles –