The Importance of Real, Nominal and Effective Interest Rates

When interest rates are calculated, the nominal interest rate is the rate that is calculated without adjustments made for inflation or the entire effect of compounding. The real interest rate compensates for the value of an investment lost with inflation. The effective interest rate, also known as the annual equivalent rate or AER, takes the effects of compounding into account.
Examples of Real, Nominal and Effective Interest Rates

Let’s say you purchase a bond for 1 year with a 6% interest rate for 12 months. If you invested $100, then your investment return would be equal to $106. This interest rate is a nominal interest rate and does not take inflation into account for that year. Now, say you purchase that same bond and taken the inflation rate of 3% for that year into account. If you purchase an item for $100 at the beginning of the year, it will cost $103 at the end of the year. So, if you invest $100 with a 6% nominal interest rate for 12 months, you lose $3 because of inflation so the real interest rate is only 3%. Finally, let’s say you invest $100 into a bond for 1 year with a 6% interest rate. Your return will be equal to $106 at the end of the year. However, if every 6 months your interest is compounded you will get a little more than $106. After 6 months, you will have gained $3 in interest. At the end of the 12 months, the bond will give you 3% interest, totalling $103 or $3.09. The return on your investment would be $106.09 for that year so the effective interest rate would be 6.09% – a bit higher than the 6% nominal interest rate.
The Importance of Interest Rates

Many interest rate calculations ignore the lender cost of borrowing funds for a certain period of time. When the loan has been repaid, the cost of items could have increased so the money is not worth as much. If you can determine what inflation will be, real interest rates can be an important tool for analyzing the worth of potential investments because the decrease in spending power is taken into account for the lifetime of the investment. The effective interest rate is also important because interest may be paid annually, monthly or weekly on different investments. The effective interest rate will allow you to compare costs or returns on various loans with greater accuracy than the nominal interest rate.
Interest Rate Tips

When inflation is increasing, then the nominal interest rate will be higher than the real interest rate. If deflation is present and inflation is decreasing, then the nominal interest rate will be lower than the real interest rate.
It is important to remember that when you calculate effective interest rates, you should not include single charges like set-up fees. Also, financial regulations have much greater control over the APR and less control over the AER.
The Fisher hypothesis says that nominal interest rates and inflation will merge over time so real interest rates have stability in the long term. This hypothesis is also known as the Fisher effect.
Some savings and bond products will connect payments to an inflation index or a real interest rate like a government issued gilt.
It may be beneficial to determine the value of investments without considering inflation. This is achieved by discounting using real interest rates.