To address this topic it is helpful to know that interest rates, unless explicitly stated otherwise, are almost always quoted in nominal terms. In other words, your mortgage rate, car loan, credit card rate, savings account rate, and so on are all quoted as nominal interest rates. If your credit card rate is quoted at 18.99%, that is a nominal rate. If your mortgage rate is 6.875%, that is also a nominal rate. In other words, ther terms “nominal interest rate” and “interest rate” are typically used interchangeably.
Now that we know the above, we can introduce the formula below. In its simplest form, the difference between real and nominal interest rates can be summarized as follows:
Real Interest Rates = Nominal Interest Rates – Inflation
That is to say that real interest rates equal nominal interest rates that have been stripped of the inflation component. It is really difficult to know the value of real interest rates. So, in practice, people typically back into the real interest rate by subtracting inflation (which is much easier to determine) from the nominal rate, as in the formula above.
Intuitively, real interest rates are the rates that would be charged if there was no inflation. In other words, the real rate would be the rate you charged someone to take possession of your money (which you can no longer use yourself) for a period of time in an inflation-free environment. If there were no inflation, there would be no risk that the purchasing power of your money would decrease when the borrower returned that money to you. However, since you didn’t get to use that money yourself, lending it to someone still else costs you something. This cost is the real interest rate. You can think of the real rate as the rate that you must be compensated in order to forgo being able to use your own money for whatever purpose you choose.
In reality there is no such thing as an inflation-free environment, so inflation will always play a role in determining nominal interest rates. Inflation is important because if I give you money for a number of years there is a chance that when you return the money to me it won’t be as valuable as it was before. For example, if I lent you $10,000 30 years ago and you paid me no interest, I would receive back $10,000 today. Unfortunately, the purchasing power of that $10,000 has greatly diminished in the past 30 years, meaning that I can now purchase far fewer goods with the $10,000 now than I could have 30 years ago. In order to compensate for this highly probable risk, when lending money I must add an additional form of compensation on top of the real interest rate. As a result, inflation is a major part of nominal rates.
When you lend money, you must get compensated for many things. For purposes of understanding the difference between real and nominal interest we will just look at two of those things:
1. The risk you are taking regarding the potential change in the purchasing power of your money (i.e. inflation)
2. The fact that you are giving up the ability to spend your own money (i.e. real interest rate)
The combination of those two factors determines nominal interest rates (more commonly known simply as “interest rates”).