The stated interest rate, also called the nominal interest rate, on an investment, such as a certificate of deposit or a savings account, helps you compare the performance of the investment to others. However, it does not give you a full picture of how your purchasing power will change when you take your money out of the account.
Nominal Interest Rate
The nominal interest rate is the interest rate used to calculate the interest earned on your account. For example, if a savings account offers an interest rate of 3.2 percent per year, that is the nominal interest rate. The nominal interest rate only shows how much the dollar amount of the account will change. It does not accurately represent how your purchasing power will change in the future as a result of the investment.
Real Interest Rate
The real interest rate takes into account inflation to measure the change in your purchasing power over the time you invest your money. When calculating the real return for past investments, you can look up the actual inflation rate. The inflation rate is not fixed, so if you want to calculate your real return in the future, you have to estimate the inflation rate. For example, if you are considering putting money in a money market deposit account for a year, you would have to estimate what you think the inflation rate will be for the year to calculate the real return.
Calculating the Real Return
To figure the real return on your investment, you need to subtract the inflation rate from the nominal interest rate. For example, if a certificate of deposit pays 5 percent interest, but the inflation rate is 2.4 percent, subtract 2.4 percent from 5 percent to find the real return equals 2.6 percent. The larger the real return, the greater the increase in your purchasing power.
Negative Real Returns
It is possible for an investment to have a positive nominal interest rate but a negative real return. This occurs when the inflation rate exceeds the nominal interest rate. For example, if you put money in a savings account that pays 2 percent interest when the inflation rate equals 3 percent, your real return is negative 1 percent. This means that even though your account balance will be higher, your purchasing power will be less. For example, after one year, a balance of $10 would grow to $12. However, a good that you could have bought for $10 a year earlier would now cost $13, so you could no longer afford it.
- New York University: Money and Inflation
- California State University Northride: Real vs. Nominal Interest Rates