Nominal Interest Rate
The interest rate that is not adjusted for inflation is known as Nominal Interest Rate. Also known as applied interest rate this is the rate on interest that is calculated what you actually owe your lender. Nominal Interest rate is always lower than APR because APR is not inclusive of all the charges.
Nominal interest rate is the stated rate of interest paid on an investment not inclusive of compounding. If your lender owes you $1,000 and charges an annual interest of $80, this means that the nominal interest rate is 8%, irrespective of whether you give the interest in quarterly installments of $20, half-yearly installments of $40 or pay the whole amount in a yearly payment. So basically nominal interest rate is when the frequency of compounding is not identical to the basic unit of time.
When inflation occurs a lender loses value on his investment and is paid back in real interest rate. Nominal rate of interest is not inclusive of any loss in value due to inflation. Therefore during inflation general price level increase causes a decline in the value of loaned amount and real interest rate is the cost of such amount after the decline in its value. Let us see how real and nominal interest rates differ.
A simple equation is used to define the relationship between real and nominal interest rates: (1 + r)(1 + i) = (1 + R) where ‘r’ is the real interest rate, ‘i’ is the inflation rate, and ‘R’ is the nominal interest rate. Also, the Fisher equation for real interest rate is, real interest rate = nominal interest rate - expected inflation. Here nominal interest rate is the stated rate and real interest rate comes after taking into consideration losses due to inflation. However, since there is no accurate estimation of the future rate of inflation real interest rate can be different before and after inflation but the nominal rate of interest is always a known figure.
Now if you buy a yearly bond at face value that gives 6% at the end of the year you stand to get $106 at the end of the year against your investment of $100 at the time you bought the bond. Hence the bond gives you an interest of 6%. This percent figure is your nominal interest rate because inflation has not been considered. Unless stated otherwise, interest therefore means the nominal rate of interest. But if the rate of inflation is at 3% in the year and the bond that cost $100 today would cost $103 the next year. Suppose you bought the bond at the value before inflation and interest rate of 6%, you can sell it the following year at $106. Now if you buy the bond at the new price of $103 you will still have a $3 additional. So taking inflation into consideration the new bond earns you $3 worth of income, which means, a 3% real interest rate. This explains the Fisher equation for real interest rate. For positive inflation rates real interest is lower than the nominal interest rate and vice versa.
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