What is the difference between real interest and nominal interest
Knowing how interest rates work, is an essential fact when we want to request a loan, mortgage or a credit in the bank. Even when we deposit our money in a bank, they offer us the possibility of obtaining an interest rate by having it deposited. But there is no general interest rate, but there are two types of interest, the nominal and the real, which fluctuate between them. To help you understand them, in .com we explain the difference between the real interest rate and the nominal interest rate.
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Nominal interest rate
The nominal interest rate is the percentage that is paid as interest on an agreed amount of money, without taking into account other expenses of any kind. Let's take a simple numerical example to help us understand it:
If we leave a friend € 100, and we will charge a nominal interest of 3%, he must return € 3 in interest and € 100 as a loan.
That is to say, it is a gross interest rate on an amount of money, it is applied on such amount without having another thing in mind. This can be paid in each installment, or at the end of the loan repayment, there are several ways that will be determined between the lender and the borrower.
Real interest rate
The real interest rate is that net return that we will obtain on the assignment of a quantity of money, once we have corrected the effects of inflation. That is, when we make a loan, that amount of money does not have the same value in the present moment as in the future when it is returned, this is due to the loss of the value of money due to inflation . That is, with a given amount of money, we can not buy the same amount of goods today, that within 5 years.
Therefore, many lenders demand a real interest rate on their loans, to make sure that in the future they will make a profit. To calculate the real interest, we must subtract the inflation rate from the nominal interest rate.
Let's go back to the previous example : We leave our friend € 100 again, with a nominal interest rate of 3%. The following year, when we repay the loan, there was an inflation of 2%. This means that, although we have applied a nominal interest of 3%, and you return € 103, the real interest rate that we have applied has been 1%, since the principal of the loan (€ 100) has less value the following year, due to the inflationary effect.
Consequence of these differences
- To those who lend money, it is convenient to make a contract with a real interest rate fixed in advance, to ensure a profit regardless of inflation.
- For those who borrow money, it is convenient for them to make a contract with a nominal interest rate and for inflation to be high, since this way, the real interest rate they have to pay back will be lower.
- The real interest rate, as its name suggests, is more realistic and better adjusted to the real evolution of the economy.
- As we do not know the future evolution of inflation, if the loan is made with a nominal interest, we will not really know until it is time to return the real interest we have paid.
- If we are in a deflationary environment, money in the future will be worth more than now, so the previous theory would be reversed. However, there are usually no deflationary situations in real life.
