Nominal VS Real Interest Rates
Learning what is interest rate is not just knowing what is interest rate itself. More than the definition, it has also different types. Among those types are nominal and real interest rates. Nominal Interest Rate is the interest rate most are familiar to. It is often called "interest rate" alone. This type of interest rate is the one applied in banks and other financial institutions. This is used for deposits, loans and amortizations. Another characteristic is that inflation is not taken into consideration, meaning inflation rate was not reduced. Other understanding towards nominal interest rate in terms of compounding is that it does not have fixed time frequency (monthly, quarterly etc.) On the other hand, Real Interest Rate is the interest rate derived from the nominal interest rate when inflation rate was subtracted. The essence of it is that to compute for the true growth value of an investment (or savings, accounts receivable) to be realized in the future, to capture a realistic result, actual (can be also expected) inflation rate is subtracted. Real interest rate = Nominal interest rate - Inflation rate Simplified example: Say, Joe has an investment that grows 3%. The inflation rate is 2.5%. Therefore Joe's investment has a real interest rate of 0.5%. At the redemption of the investment, 0.5% of growth is actually realized.