Definition: Real interest rate represents the actual percentage return of a security or a loan calculated by subtracting the inflation rate from the nominal rate.
What Does Real Interest Rate Mean?
What is the definition of real interest rate? Unlike the nominal interest rate, which does not consider inflation, the RIR gives an idea about the real cost of money borrowed and the real yield of an investment. In doing so, the real value of money increases over time, thereby increasing the purchasing power of consumers and the yields in the portfolio of an investor.
If the inflation is higher than the nominal interest rate, the real interest may also be negative, in which case, investors lose their purchasing power and should proceed with alternative investments. The real interest rate formula equals the nominal interest rate minus the inflation.
Let’s look at an example.
Peter owns a corporate bond that pays a 5% coupon. If the inflation rate is 2%, then the RIR of the coupon is 3%. If the inflation rises to 6%, then the RIR of the coupon is -1%. In this case, Peter loses 1% of his money. This is most effective in savings accounts. For instance, if a savings account pays 2% a year, but inflation is 4%, the account holder loses 2% of the money in the account.
The main determinant of the RIR is inflation as it lowers the value of the expected cash flows, not only with respect to savings accounts but also in salaries and pensions. Peter is considering another investment that promises to deliver a net worth of $100,000 20 years later at an annual interest rate of 5%. Peter, therefore, should consider the inflationary effects on this investment and estimate the real value of money after 20 years.
Also, if Peter decides to borrow $50,000, he should consider if the RIR is higher than inflation. In this case, if Peter borrows at 5% and inflation is 6%, then he will see a decline in the borrowed funds by 1%.
Define Real Interest Rate: RIR means the percentage return an investor or depositor expects to actually receive after inflation is taken into consideration.