Nominal Interest Rate
Candlefocus EditorThe nominal interest rate is the rate that most borrowers and lenders focus on due to the relative simplicity of understanding. For example, if a borrower takes out a loan that has a 6% nominal interest rate, they expect to pay 6% interest on the loan amount. The same holds for lenders, for example, if a bank offers a 6% interest rate on a 10-year certificate of deposit, the depositor expects to receive 6% interest on the deposit over the 10-year term.
Inflation is however, often overlooked as an important factor when considering nominal interest rates. During periods of high inflation, the nominal interest rate may not accurately represent the return on investment or the cost of borrowing in terms of purchasing power. For example, if a borrower takes out a loan with a 6% nominal interest rate when inflation runs at 6%, then the real interest rate — or the return in terms of purchasing power — is 0%. On the other hand, if a lender offers a 4% interest rate when inflation runs at 6% then the real annual percentage yield (APY) of the investment is -2%.
This is why the real interest rate is preferred to the nominal interest rate by most investors. The real interest rate takes into account the fluctuations of purchasing power to predict the return on investments or the cost of borrowing. The calculation for the real interest rate is the nominal interest rate minus the rate of inflation.
In conclusion, nominal interest rate is the rate of interest mentioned in the loan agreement or certificate of deposit. It is the rate borrowed or lent from a financial institution or lender and is not necessarily representative of the actual return or cost in terms of purchasing power. APY (annual percentage yield) is the effective interest rate and most relevant for borrowers and lenders in evaluating the true rate of return than the nominal rate. The real interest rate is calculated by subtracting the rate of inflation from the nominal rate and gains importance to investors as it tends to accurately reflect the return on investments or cost of borrowing.