Which is better nominal interest rate or real interest rate?

A nominal interest rate is one that does not adjust for inflation. You may see a nominal interest rate advertised for a product such as a mortgage or a high-yield savings account. A real interest rate is one that has been adjusted for inflation, to show the real cost and purchasing power of money that is lent or invested.

The nominal interest rate shows the price of money and reflects current market conditions. It may be influenced by the Fed funds rate or another benchmark rate. This nominal interest rate tells you how much money you will either pay (such as in interest on a loan) or receive (such as interest on a savings account). The real interest rate is what tells you how much purchasing power you as an investor or saver, or a lender, actually earns from that interest.

What’s The Difference Between Nominal and Real Interest Rates?

Simply put, the real interest rate is the nominal interest rate minus the inflation rate. For example, if a nominal interest rate was 2% and the inflation rate was 1%, the real interest rate would be 1%.

Inflation

The nominal rate of interest is the rate available to consumers and businesses looking to borrow money or earn interest in an account. It continually changes as it’s influenced by monetary policy, investor sentiment, and other market conditions, including the expectation of inflation (but not actual inflation). For example, if an interest rate on a savings account is 0.4% and based on the Fed funds rate, it could increase to 0.5% if the Fed funds rate increased first.

Note

Interest rates offered by lenders, banks, credit unions, and other financial institutions vary widely and may also reflect their business strategies and expectations of profits.

Nominal interest rates already account for inflation expectations. If the Federal Reserve predicts high inflation, it may increase the target Fed funds rate, which impacts many other interest rates, such as those offered on mortgages, auto loans, savings accounts, and other financial products.

Since nominal interest rates are based on the expectation of inflation or deflation, it’s important to know about other products or investments that adjust for actual inflation. These products or investments show the real interest rate.

The Federal Reserve publishes interest rates on its website daily. These rates are used as benchmarks for interest rates on savings accounts, mortgages, and more. They include the Federal funds rate; Treasury bonds, notes, and TIPS yields; and the average bank prime rate. There are also regular surveys of consumers and economists, and Federal publications of inflation expectations, which lenders and financial institutions incorporate into their rates.

Cost of Money vs. Purchasing Power

Nominal rates of interest represent the actual cost of money to businesses and consumers. They measure how much you pay or receive in interest, but not what that money can buy, also known as purchasing power. Here’s how that works.

Suppose you deposit $10,000 in a one-year certificate of deposit (CD). At the end of one year, the bank pays you 1% on top of the principal, so you receive $10,100.

In the beginning of that year before you deposit that money in the CD, your $10,000 could buy a basket of goods for $10,000, leaving you with $0. By the end of that year, after 1% inflation, that same basket of goods costs $10,100. When your CD matures, you have an extra 1% that you earned in interest, but you have nothing left if you use that money to buy that same basket of goods. Inflation canceled out your earnings.

Nominally, you had an extra $100 that you earned in interest on the CD. In reality, you have the same purchasing power that you had before because of 1% inflation over the course of that year. In this example, the nominal interest rate is 1% and the real interest rate is 0%.

What It Means for Investors

When nominal interest rates are higher than inflation rates, real interest rates are positive. When nominal interest rates are lower than inflation rates, real interest rates are negative. This is important to understand when looking at interest rates on investments in comparison to current inflation rates.

For example, between March 2020 and December 2021, real interest rates as measured by the 10-year TIPS yield were negative. This is because when daily Treasury yield curve rates are below the expected inflation rate, TIPS yields fall into negative territory. When this happens and the real interest rate is negative, rather than earn interest on an investment in TIPS, you’d be paying money to hold the TIPS investment instead.

TIPS stands for Treasury Inflation-Protected Securities. They are investments that pay interest and adjust the principal based on the Consumer Price Index (CPI). So if the CPI increases, the principal adjusts up, but if it decreases, the principal adjusts down.

Note

TIPS are available in five-, 10-, and 30-year maturities. TIPS pay interest twice per year on the adjusted principal. The greater of the original or adjusted principal is paid at maturity.

So why would someone invest their money in TIPS?

In times of rising inflation, TIPS may seem like a relatively safe investment option. TIPS investments won’t meet investor expectations if inflation rates don’t rise to expected levels or if real TIPS yields are negative. However, despite negative real yields, some experts consider TIPS one of the easiest ways for investors to protect their portfolios from inflation over the long term.

Another explanation could be uncertainty and the “flight to safety” phenomenon. You may be willing to pay a small premium for assets such as bonds or TIPS that have little or no risk to principal. You may consider this a safer choice than investing in stocks or exchange-traded funds (ETFs) on the stock market during volatile or uncertain economic times.

Negative real interest rates such as the 10-year TIPS yield are unusual, but they do happen. Before 2020, the last time the 10-year TIPS yield went negative was in December 2011. They remained there until May 2013, when bond investors started selling bonds after Federal Reserve Chair Ben Bernanke said the Fed would start tapering asset purchases. This caused a spike in interest rates, known as the “taper tantrum.” Since bond prices move in the opposite direction of interest rates, this spike caused bond prices to fall.

A similar announcement came in July 2021 when the Fed said that it would slow bond purchases toward the end of the year. This time though, there was no “taper tantrum” in response and yields remained about the same.

Note

Negative real interest rates in the U.S. don’t happen too often. In the past, they have usually been a result of extraordinary interventions by the Fed.

The Bottom Line

Nominal and real interest rates are important because they play different roles in your financial decisions. If a real interest rate is positive, it means you have more purchasing power. If the real interest rate is negative (nominal rate minus the inflation rate), then it means you have less purchasing power—at least when it comes to investments and earning interest on your money.

When it comes to borrowing money, negative real interest rates may influence borrowers, such as potential homeowners who see low interest rates as an attractive time to buy, thus pushing up the demand for houses and their prices. At the same time, businesses may be more inclined to borrow money to finance projects or acquisitions. On the other hand, conservative investors may face difficult choices as to where to put their money.

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