Knowing how interest rates work is an essential data when you want to apply for a loan, mortgage or credit to the bank. Even when you deposit your money in a bank, you are offered the opportunity to get an interest rate for depositing it. There is not a single general interest rate, but two, the nominal and the real, that fluctuate relative to each other. To help you understand them, on dotenvironment.net, we explain the difference between real interest rate and nominal interest rate.
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Nominal interest rate
The nominal interest rate is the percentage that is paid as interest on an agreed amount of money, without taking into account all other expenses. Here is a simple numerical example to help you understand:
If you lend to a friend 100 DOLLARS and agree to a nominal interest of 3%, he will have to return 3 DOLLARS as interest and 100 DOLLARS as the loan.
That is, it is a type of gross interest on a quantity of money. It applies to a given quantity without taking any other factor into account. It can be paid in several times, or at the end of the loan. There are several ways of doing that are agreed between the lender and the borrower.
Real interest rate
The actual interest rate is the net rate you will get on the assignment of a quantity of money, once you have corrected the effects of inflation. That is, when you make a loan, that amount of money does not have the same value now and in the future when you repay it because of the loss of the value of the loan. By the effect of inflation. That is, with a given amount of money, you will not be able to buy the same amount of goods today as in 5 years.
This is why many lenders require in their loans a real interest rate, to ensure obtaining a profit in the future. To calculate the real interest, you have to subtract the nominal interest rate from the inflation tax.
Returning to the previous example: You leave your friend 100 DOLLARS again, with a nominal interest rate of 3%. The next year, when he returned the loan, there was inflation of 2%. This means that, although you have applied a nominal interest of 3% and you owe DOLLARS 103, the real interest rate you applied is 1%, as the majority of the loan (DOLLARS 100) less value the following year, by the effect of inflation.
Consequences of these differences
Those who lend money like to make a contract with a real interest rate fixed in advance, to ensure a profit regardless of inflation.
Those who ask for lent money prefer to make a contract with a nominal interest rate because if inflation is significant, the real interest rate they have to make will be less.
The real interest rate, as its name suggests, is more realistic and better adjusted to the real evolution of the economy.
Since the future evolution of inflation is not known, if the loan is made with a nominal interest , you are not really sure how much you will have to repay until the end of the loan.
If you find yourself in an environment of deflation, money in the future will be worth more than at the present moment, so the previous theory is reversed. However, situations of deflation do not exist in real life.