What Is the Real Interest Rate?

The “interest rate” you see on paper on your credit card or loan statement is actually the nominal interest rate. So what are you actually paying?

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- [Narrator] What is
the real interest rate?

Well, first let's start with
what the nominal interest rate is.

That's the interest rate you see
on a bank or credit card statement.

So when people say interest rate,

they usually mean
nominal interest rate.

To see the difference

between nominal
and real interest rates,

let's turn to an example.

Suppose that a bank lends $100
at a nominal interest rate of 10%,

but suppose also that over the year
the inflation rate is 10%.

At the end of that year,

the borrower
pays back the bank $110.

That looks pretty good on paper,

but during the year,
money has become less valuable.

Due to inflation, what used
to cost $100 now costs $110.

So what is the bank's real return?

Zero.

More generally, we can write
that the real interest rate

is equal to the nominal rate,
the rate charged on paper,

minus the inflation rate.

Inflation reduces
the real return on a loan.

So unexpected inflation
can redistribute wealth

from the lender to the borrower,

and that's exactly what happened
in the 1970s in the United States.

Suppose, for example,

that you had taken out
a home mortgage in the 1960s.

As a borrower,
you'd have done really well

because few people anticipated

the high inflation rates
of the 1970s.

So borrowers ended up paying off
their mortgages in dollars

that were worth a lot less
than anyone had expected.

As you can see, in order
to understand interest rates,

understanding inflation is crucial.

If you'd like to learn more
about inflation, click here.

Or, if you'd like
to test your knowledge

on the real interest rate,
click here.

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