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What is a Nominal Interest Rate?

Adam Hill
Adam Hill

An interest rate is a percentage of an amount of money, which a borrower pays a lender for the privilege of borrowing it. Most interest rates are quoted as a nominal interest rate, meaning one that is not adjusted for inflation. This rate does not take into account the fact that the value of money changes and decreases over time due to inflation. This is not necessarily a bad thing, since it is impossible to predict future inflation, and because a fixed rate of return for borrowed funds must be agreed upon beforehand.

A nominal interest rate is one such as the interest rate on a mortgage, or the interest one might earn on a high-yield savings account. It is the interest rate as stated. This is distinct from what is called a real interest rate, which is one that has been adjusted for inflation. Real interest rates are usually lower than nominal interest rates. For example, if a bank customer puts $1,000 US Dollars (USD) in a certificate of deposit which offers a five percent rate of return, then at the end of a year, there will be $50 USD more in the account, bringing the total to $1,050 USD.

Man climbing a rope
Man climbing a rope

Five percent is the nominal interest rate in the above example. However, if inflation for that year is calculated to be two percent, while this does not affect the nominal interest rate, it does affect the real interest rate. The customer's dollars may have increased by five percent, but if all money becomes worth two percent less over that time in terms of purchasing power, the real interest rate was actually only three percent. Of course, a three percent real interest rate is better than the two percent decrease in value that the depositor would have experienced otherwise, and this is likely why he put his money on deposit -- to maintain its purchasing power.

In times of rapid inflation or other forms of economic turmoil, the nominal interest rate may only decrease the otherwise larger loss of a person's purchasing power. If real interest rates are zero, or even negative, even a positive nominal interest rate may deliver a negative real rate of return. Fortunately, conditions such as these are rare in developed countries, and even then, the nominal interest rate will still offer some comparative benefit. In addition to interest rates, the terms "nominal" and "real" can apply to many types of economic data, such as wages, government expenditures, and a country's gross domestic product, among other things.

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specific and logical!

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