Fact checked by Vikki Velasquez
Multiple economic factors influence interest rates. Three types of interest rates, including real, nominal, and effective affect consumers’ borrowing and investment choices.
Key Takeaways
- The nominal interest rate is the actual price borrowers pay lenders.
- The real interest rate accounts for inflation and better defines a consumer’s purchasing power.
- The effective interest rate includes compounding.
Nominal Interest Rate
The nominal interest rate is the stated interest rate of a bond or loan or the actual price borrowers pay lenders to use their money. If the nominal rate on a loan is 5%, borrowers can expect to pay $5 of interest for every $100 loaned to them. This is often referred to as the coupon rate because it was traditionally stamped on the coupons redeemed by bondholders.
Nominal interest rates are not adjusted for inflation. They are typically expressed annually, such as 5%, 7%, or 10%, and represent the percentage of the loan amount or investment principal that must be paid as interest during a specific period.
Important
Real interest rates can be negative. Even if the nominal rate is positive, inflation can erode purchasing power.
Real Interest Rate
The real interest rate includes inflation to give investors a more accurate measure of their buying power. If an annual compounding bond lists a 6% nominal yield and the inflation rate is 4%, then the real interest rate is 2%.
Real interest rates are crucial in investments and loans. When assessing investment opportunities or evaluating the cost of borrowing, individuals must consider the real interest rate to understand the true economic impact and how inflation may affect the return on investment or the actual cost of borrowing.
Effective Interest Rate
The effective interest rate includes the concept of compounding. If a bond pays 6% annually and compounds semiannually, an investor who places $1,000 in this bond will receive $30 of interest payments after the first six months ($1,000 x .03), and $30.90 of interest after the next six months ($1,030 x .03). In total, this investor receives $60.90 for the year.
In this scenario, while the nominal rate is 6%, the effective rate is 6.09%. The difference between the nominal and effective rates increases with the number of compounding periods within a specific timeframe.
Applying Rates
Many financial contracts such as mortgages, personal loans, and credit cards, specify the nominal interest rate that will be applied to the principal amount.
Real rates are used when analyzing investment decisions. Real interest rates help determine the actual purchasing power of the investment return after accounting for inflation. They are useful for consumers planning for long-term financial goals like retirement. International investments may call for real rates as different regions may be impacted by differing macroeconomic policies.
Investors seeking protection from inflation in the fixed-income arena may consider Treasury Inflation-Protected Securities (TIPS), which pay interest rates indexed to inflation. Alternatively, mutual funds investing in bonds, mortgages, and senior secured loans that pay floating interest rates, periodically adjust with current rates.
Effective interest rates are not appealing to borrowers as they reflect higher costs. However, effective interest rates help savers who earn more with more compounding periods.
Rate Regulation
Many countries have regulations that mandate financial institutions to provide clear and transparent information about interest rates to consumers. In the U.S., the Truth in Lending Act requires lenders to disclose the APR to borrowers. The APR represents the effective interest rate and includes fees or costs involved in the loan.
In the U.K., the Consumer Credit Act regulates consumer credit agreements and protects borrowers. It applies to various credit arrangements, including loans, credit cards, and hire-purchase agreements. The Act requires lenders to provide clear and transparent information to consumers about the cost of credit. It sets rules on credit advertising and marketing practices.
Example
A consumer may purchase a car and take out a car loan from a bank. The bank offers the following terms:
- Nominal Interest Rate: 6% per year
- Loan Term: 5 years (60 months)
- Loan Compounding Frequency: Monthly
- Inflation Rate: 2%
The nominal rate is the stated annual interest rate. However, this rate does not account for compounding throughout the loan.
The effective rate accounts for the impact of compounding. In this example, the compounding frequency is monthly. To calculate the effective interest rate:
Effective Interest Rate = (1 + (Nominal Interest Rate / Number of Compounding Periods))^(Number of Compounding Periods) – 1
Effective Interest Rate = (1 + (6% / 12))^(12) – 1 ≈ 6.17%. This rate reflects the true cost of borrowing, accounting for monthly compounding.
The real rate includes the inflation rate. The real interest rate is 4%. (6% nominal rate less 2% inflation).
These three rates, all accurate and related to the same loan, range from 4% to 6.17%. Over the life of the auto loan, even one to two percentage points may amount to hundreds of dollars of extra charges and compounded for larger loans such as mortgages.
What Factors Influence Changes in Nominal Interest Rates?
Nominal interest rates can be influenced by economic factors such as central bank policies, inflation expectations, credit demand and supply, overall economic growth, and market conditions.
Why Do Effective Interest Rates Matter for Borrowers?
Effective interest rates matter for borrowers because they reflect the true cost of borrowing, including compounding. Borrowers can use effective rates to compare loan offers accurately and understand the total amount they will repay.
How Do Central Banks Use Nominal and Real Interest Rates in Monetary Policy?
Central banks set nominal interest rates as part of their monetary policy to influence economic activity. They use real interest rates to gauge the stance of their policy after considering inflation, helping to ensure stable economic growth and maintain price stability.
What Are Negative Interest Rates?
Real interest rates are negative if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1%, if the inflation rate is 4%. Negative rates affect lenders, borrowers, and investors. Investors with longer time horizons should assess their investment returns on an inflation-adjusted basis.
The Bottom Line
When considering interest rates, investors and borrowers must look beyond nominal or coupon rates when considering their overall investment objectives. A qualified financial advisor can help consumers navigate interest rates that keep up with inflation and determine the true cost of debt.