A real interest rate is the ir that takes inflation into account, giving a clearer picture of what borrowing actually costs and what lenders or investors can expect to earn. We will call interest rate as ir in this post.
This rate shows how much people value having goods now compared to later. To figure out the real ir for an investment, you simply subtract the inflation rate from the nominal interest rate:
Real interest rate = nominal interest rate – inflation rate (whether expected or actual).
Learn more about Real Interest Rate
The nominal ir is what you actually pay on a loan or earn from an investment, while the real ir shows how much your purchasing power changes because of that investment or what you’re giving up as a borrower.
Typically, the nominal ir is the one you see advertised by banks or lenders. When you adjust this rate for inflation, it helps you understand how the value of your money changes over time.
According to the time-preference theory of interest, the real ir indicates how much someone values having goods now compared to later.
Borrowers who want to use money right away tend to have a higher preference for current goods, which means they’re okay with paying a higher ir for loans.
On the flip side, lenders who prefer to wait and consume later have a lower time preference and are more likely to offer loans at a lower ir. Adjusting for inflation can help clarify how much time preference exists among people in the market.
Conclusion
The real ir is the ir that takes inflation into account, showing the actual cost of borrowing for someone and the true return for a lender or investor. It indicates how much people prefer to have goods now rather than later and is figured out by subtracting the inflation rate from the nominal ir.