Types of interest rates & Real rate of Interest

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Types of interest rates

There are essentially three main types of interest rates: the nominal interest rate, the effective rate, and the real interest rate.

What is a Real Interest Rate?

An interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower, and the real yield to the lender. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate. A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. The real interest rate reflects the rate of time-preference for current goods over future goods. The real interest rate of an investment is calculated as the difference between the nominal interest rate and the inflation rate: 

SUMMARY:

  • The real interest rate adjusts the observed market interest rate for the effects of inflation.
  • The real interest rate reflects the purchasing power value of the interest paid on an investment or loan and represents the rate of time-preference of the borrower and lender.
  • Because inflation rates are not constant, prospective real interest rates must rely on estimates of expected future inflation over the time to maturity of a loan or investment.
  • According to the time-preference theory of interest, the real interest rate reflects the degree to which an individual prefers current goods over future goods. A borrower who is eager to enjoy the present use of funds shows a stronger time-preference for current goods over future goods and is willing to pay a higher interest rate for loaned funds. Similarly a lender who strongly prefers to put off consumption to the future shows a lower time-preference and will be willing to loan funds at a lower rate. Adjusting for inflation can help reveal the rate of time-preference among market participants.

Example of real interest rate:

An investor were able to lock in a 5% interest rate for the coming year and anticipated a 2% rise in prices, they would expect to earn a real interest rate of 3%.

=5% - 3% = 2% 

The expected real interest rate is not a single number, as different investors have different expectations of future inflation. Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower.




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