Real Interest Rate: Definition & Calculation

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  • 0:00 What is Real Interest Rate?
  • 0:47 Calculating Real Interest Rate
  • 1:15 Practice
  • 2:25 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
An investment that pays 10% interest doesn't guarantee that you'll have a 10% increase in purchasing power. In this lesson, you'll learn about the real interest rate and how to calculate it.

What Is Real Interest Rate?

When you look at your credit card statements, loan documents, or savings account, you're usually seeing the nominal interest rate. The nominal interest rate is not adjusted for inflation, but the real interest rate is an interest rate that is adjusted for inflation. Remember that inflation is a rise in the general price level in an economy. In simple terms, a dollar today is usually worth more than it is tomorrow because the costs of goods and services are usually cheaper today than they will be tomorrow. While the nominal interest rate will tell you how fast your investment will increase in dollars over time, the real interest rate will tell you how fast your purchasing power will increase in time. If inflation is higher than your interest rate, you actually are losing purchasing power.

Calculating Real Interest Rate

Why do we need to calculate real interest rate? Well, it gives you a clear picture of how much loans cost you and how much you are actually increasing your purchasing power with an investment. And if you are a lender or investor, you want to ensure the interest rate you're charging on your loan, or the rate of return on your investment, is at the very least keeping up with inflation.

Fortunately, the formula for real interest rate is quite simple:

Real Interest Rate = Nominal Interest Rate - Inflation Rate

Practice

Let's practice using the real interest rate formula. Imagine that you are a loan officer at a local community bank. The bank has approved a loan for one of your clients at an interest rate of 10%. The current inflation rate is 3%. What is the real interest rate? Start with the formula, which is:

Real Interest Rate = Nominal Interest Rate - Inflation Rate

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