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Differences between Nominal and Real Rates of Return
Interest rates are a very important part of the investment process, and investors usually invest their money depending on the interest rates. It is impossible to think about investment without considering interest rates. There are mainly two types of interest rates which the investors are concerned with. These are −
- Nominal Interest Rate
- Real Interest Rate
Let’s consider the definitions of each one of the interest rates and then find out the differences between the two.
Nominal Interest Rate
The nominal interest rate is the rate an investor has to pay in the market without considering the rate of inflation. For example, the rates of financial institutions such as banks, and loan offering firms are nominal interest rates.
The nominal interest rate is easy to understand and calculate.
For example, if you have INR 100 and the interest rate of the investment is 6%, you will have INR 106 in the account at the end of the year.
Similarly, if you’ve borrowed INR 100 from someone and the interest rate is 4%, you will have to pay INR 104 at the end of the year.
Real Interest Rates
Real interest rates are interest rates that consider inflation. Inflation is the percentage of an increase in the price of goods. Therefore, the real interest rates consider the general rise in the prices of goods.
For example, say, you have invested INR 100 in a bank and the interest rate is 5%. Now if the inflation is 3%, the effective interest rate will be 5% minus 3% = 2%. So, you will get INR 102 in your account at the end of the year.
Key Differences between Nominal and Real Interest Rates
Both nominal and real rates of returns are rates that you will have to pay if you invest or borrow funds. But, there are some key differences between them.
As mentioned above, the nominal rate of return does not consider inflation. However, the real rate of return is adjusted for inflation.
The nominal rate of return is the market rate of interest while the real rate of return is an adjusted and realized rate of interest.
Bank loans and interest rates are nominal rates of return while the real rates are derived from the nominal rates.
The real rate of interest considers the time value of money and inflation etc. However, no such adjustment is considered in real interest rates.
The nominal rate of interest can go down to zero but it cannot be negative. However, the real rate of interest can go further below zero and can be negative.
Nominal rates show what is going on in the market and they are not real interests earned, but real interest rates are real rates that are applicable in day-to-day financial activities.
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