What is a Nominal Interest Rate?

//What is a Nominal Interest Rate?
What is a Nominal Interest Rate? 2017-10-06T02:01:27+00:00

Definition: The nominal interest rate is the percentage yield of a security or a loan without considering the effect of inflation. In other words, it’s the actual rate that borrowers pay to lenders to use their money.

What Does Nominal Interest Rate Mean?

What is the definition of nominal interest rate? The coupons that bond investors receive are calculated with a nominal interest rate because they measure the percentage yield of the bond based on its face value.

Therefore, a 25-year municipal bond with a face value of $5,000 and an 8% coupon ratethat pays interest every year, will return the bondholder $5,000 x 8% = $400 annually for 25 years. If we subtract inflation from the nominal interest rate, we derive the real interest rate, which is the rate that the deposits are calculated on.

Let’s look at an example.

Example

At the beginning of 2015, Markus deposits $1,500 in a checking account with a 6% annual interest rate. At the end of the year, the value of his deposit is $1,500 x (1 + 6%) = $1,590.

If inflation were 0%, the general price level would not change during the year; therefore, Markus would be able to buy 6% more goods and services that he was able to buy a year earlier with $1,500. Therefore, the nominal interest rate would be 6%.

However, with an inflation rate of 6%, Markus has $1,590, but the real value of his deposit this year is not higher than the value of his deposit a year earlier. Markus can buy the same goods and services that he could buy a year earlier although he has more money.

In fact, an inflation rate of 6 percent essentially means that the products and services are more expensive by 6% on average. Therefore, Markus receives a nominal interest rate of 6% and a real interest rate of 6% – 6% = 0%.

Summary Definition

Define Nominal Interest Rate: A nominal interest rate is the interest percentage of a note or security with out regard to inflation.