The issue of interest rates is one of the most tricky parts of the financial industry. Financial managers and investors are making financial decisions linked to their exact needs and risk profiles mainly based on the interest rate. However, it should be underlined, that risk management or data analysis cannot be done for sure for long-term investments, as the factor of inflation exists. This is the main focal factor why the financial institutions apply two types of interest rates: the nominal interest rate and the real interest rate.
Breakdown of the Nominal Interest Rate
The nominal interest is generally well-known as a rate of return that the borrower might get or, alternatively, pay without taking into account the rate of inflation. For instance, the interest rate of bank accounts, loans, or bonds are deemed to be nominal and no inflation affects them. Let's exemplify the case: you have $2500 in your bank account with an offer of 5 percent of the annual interest rate. At the end of the year, the bank will be obliged to pay back the lump sum of your deposit plus the 5 percent of annual interest.
The Real Interest Rate
The understanding of the nominal interest rate is nearly a simple conception. However, the calculation of the real interest rate may be much more difficult, when we are starting to deal with inflation. For instance, if you have a deposit with the bank for $1000 with a nominal interest rate of 5 percent per annum, you will not be paid exactly 5 percent of the deposited amount at the end of the year. Why? The main reason is regarded to be the inflation rate, let’s fix it 3 percent. Consequently, against your deposit of $1000, you will be paid $20 interest. By the way of explanation, the real interest rate equals the nominal interest rate plus the annual inflation.
Major Disparities Between the Nominal and the Real Interest Rates
The conception of interest rate provides an opportunity to understand what the customer may expect to earn from his/her investment and, alternatively, pay in case of loans. Here are illustrated the focal disparities between nominal and real interest rates:
- The nominal interest rate is considered to be the exact rate of return that customers are obliged to pay or earn based on the exact cases. Meanwhile, the real interest rate comprises the phenomenon of annual inflation.
- The annual inflation rate has no effect on nominal interest rates, whereas, the calculation of the real interest rate includes the removal of the inflation influence
- Real interest rates are emanated from the nominal interest rate: nominal rate - inflation rate = real rate
- In the case of real interest rates the issue of “time value of money” plays a great role
- The lower limit on the nominal interest rate can be 0%, meanwhile, the real rate may even be negative, based on the fact of high inflation. For example, the nominal interest rate is 2% and the inflation rate is 3 %, it means that the investor may lose the amount equivalent to the negative interest rate.
APRs of Payday Loans
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