Real Interest Rate
What is Real Interest Rate?
The real interest rate is the nominal interest rate minus the inflation rate, showing the true cost of borrowing or return to saving.
It measures the actual purchasing power gained or lost over time. A positive real rate incentivizes saving, while a negative rate discourages it. It is the key determinant of investment in the loanable funds market.
Real Interest Rate: a worked example
A credit union lends 900 dollars for one year at a nominal rate of 9 percent while both sides expect 4 percent inflation, so the expected real rate is 9 - 4 = 5 percent. Inflation instead comes in at 7 percent. The borrower repays 900 x 1.09 = 981 dollars. Meanwhile a basket of goods that cost 900 dollars at the start of the year now costs 900 x 1.07 = 963 dollars. The repayment buys only 981 - 963 = 18 dollars more than that original basket, which is 18 / 900 = 2 percent of what was lent. That matches the realized real rate of 9 - 7 = 2 percent. The lender planned on 5 percent of purchasing power and collected 2 percent.
The mistake students make with real interest rate
Mixing dollars and percentages inside one subtraction. On the loan above, interest is 900 x 0.09 = 81 dollars while inflation erodes 900 x 0.07 = 63 dollars of the principal's purchasing power. Students report the leftover 18 dollars as the real interest rate. Eighteen dollars is the real gain, not a rate, so divide by the 900 lent to get 2 percent. The mirror version is writing 81 dollars minus 7 percent, which subtracts a percentage from a dollar amount. Keep both terms in matching units, either two rates or two dollar figures.
Real Interest Rate questions
How do you find the real interest rate from a price index?
Convert the index into an inflation rate, then subtract. If a price index moves from 125 to 130, inflation is (130 - 125) / 125 = 4 percent. Subtract that from the nominal rate, so a 6 percent nominal rate leaves a real rate of 2 percent. The common wreck is subtracting the index number itself rather than the percentage change it implies, which produces an impossible answer like negative 124 percent.
Can the real interest rate be negative?
Real interest rates turn negative whenever inflation exceeds the nominal rate. A savings account paying 2 percent while prices rise 5 percent delivers a real return of 2 - 5 = -3 percent, so the money in the account buys less at the end of the year than it did at the start. Negative real rates punish savers and reward borrowers, who repay loans with dollars worth less than the ones they received.
Who gains when inflation is higher than expected, borrowers or lenders?
Borrowers gain and lenders lose. Both sides agreed on a nominal rate built from the inflation they expected, so when actual inflation overshoots, the realized real rate falls below the one written into the deal. A loan signed at 9 percent nominal with 4 percent expected inflation was meant to deliver 5 percent real, but 7 percent actual inflation leaves the lender with only 2 percent. Unexpectedly low inflation reverses the transfer and favors the lender.
Formula / Example
This is the live Loanable Funds sandbox. Drag the curves, or open the full version.
Related terms
The same idea in another course
The same adjustment on a real portfolioThe Fisher adjustment applied to an actual return, with the approximation and the exact form compared. On FinanceLearn, a sister site.
Common comparisons
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