What do we mean by the Real Interest Rate?
A borrower of funds has to pay interest at a certain rate to the lender. Also, an investor can earn interest on his deposits and investments with a bank or a financial institution. In both cases, the user of the funds pays interest to the lender or depositor for allowing him to use the funds. The interest rates appearing on the deposits and loan agreements are the nominal interest rates. While what the lender or the depositor effectively earns on his money after the inflation effect is the Real interest rate.
Therefore, we adjust the nominal interest rate on a deposit or an investment for the effect of inflation to arrive at the real interest rate. We take into account the effect of compounding too. Also, various charges, commissions, and fees that a bank or a financial institution may charge have to be taken into consideration to arrive at the real rate of return.
Why to Calculate Real Interest Rate?
Banks and financial institutions disclose the nominal interest rate on a loan or an investment. Other private lenders and institutions also do the same. Hence, it is up to the prudence of the borrower or investor to correctly gauge the real interest rate. It will determine his true earnings or the amount he will have to pay. Incorrect calculations and faulty judgment can result in the loss of valuable time and money for the parties to the contract. It can make the entire exercise of investment of money over the contract period useless. A lender or an investor should ascertain that the inflation rate should not be more than the nominal interest rate over the contract period. This will ensure that he makes a profit from the contract.
How does the Real Interest Rate Work?
Suppose a bank gives a 10% p.a. interest rate on a specific deposit account of $1000. It does not mean that the depositor will get richer by $100 (10% of $1000) at the end of the first year in the true sense. In reality, he will not be able to buy 10% more goods at the end of the first year than what he can buy at present. This is because of the impact and effect of inflation during the year.
Unless there has been no inflation rather deflation during the period. And that we can call an exception. Because all the economies are progressing in general, and inflation is a part of that growth characteristic. This inflation takes away the effective purchasing power of the money over time.
Example and Formula
Now suppose the inflation rate in the economy is 4% for the year under consideration. The rates of the goods and services that the investor consumes have gone up by 4% on average. Therefore, he will be able to buy only 6% (10% – 4%) more goods at the end of the year rather than the entire 10%.
In the above example, 10% is the nominal interest rate that the banks or any other financial institution will disclose to their customers. 6% is the real interest rate that the investor will actually earn on his investment in that year. Therefore the formula to calculate the real interest rate is:
Real interest rate= Nominal interest rate – Inflation rate
What are the Limitations of using the Real Interest Rate?
Uncertainty of Inflation Rate
The future is uncertain, and so is the inflation rate. An investor or a lender cannot predict the inflation rate that will prevail during his investment or loan tenure. Hence they have to rely upon predictions and anticipations of the future rate of inflation. A high rate of inflation will hurt the lender during the loan period. However, the borrower will benefit from such a situation.
Status of a Lender
Suppose a lender, be it an individual or a bank, lends money for a year at a nominal interest rate of 10% p.a. He predicts the inflation rate during the same period to be 4% p.a. Therefore, as per his calculation, his real interest rate over the period should be 6% (10% – 4%). But suppose the actual inflation rate is 7% p.a. during that period. The lender only receives 3% (10%-7%) as the real interest rate. He loses out on his interest rate, which can hurt badly. He may be better off by investing that same amount of money in some other option with a better return.
Status of a Borrower
Now let us look at the same situation from the borrowers’ point of view. He has to pay back the loan amount as pre-decided at the end of the loan tenure. But a higher inflation rate will mean that that sum of money has a relatively lower value in real terms. This is because of a loss in purchasing power of money due to inflation. Hence, he stands to be better off and benefit from the situation.
Status of an Investor
Similar is the case for an investor anticipating a fixed rate of return on his investment. The uncertainty of the inflation rate can result in a low real interest rate at the end of the investment tenure. He may also lose out on interest income in the real sense. He could have earned more investing in some other option.
The real interest rate is generally of more use than the nominal interest rate in the financial world. Everyone wants the maximum returns possible from their loans or investments. This rate gives a comparatively better vision of the returns on the funds lent that a lender will get at the maturity of the loan. An investor also gets to know the best option for investment after comparing the real rates of return of two or more investment options.
The real interest rate gives the actual returns after not just considering the inflation rate. But also a myriad of charges, commissions, and fees that the loan providers may charge. These charges and commissions can also lower the returns that an investor will actually earn at the end of the investment period. From an investor’s point of view, it is very helpful as it takes into account the effect of compounding as well. This can help him to understand the real returns from investments, especially those that span beyond a couple of years or more.
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