The nominal rate is the quoted interest rate that is being paid to the lender by the borrower in a debt agreement. This rate is not adjusted for inflation, even though rising prices can affect the value of the return from the interest payments. Since inflation nearly always exists in most modern economies, it can be more helpful for individuals to judge their investments in terms of the real interest rate. Calculating the real interest rate is accomplished by taking the nominal rate and subtracting from it the rate of inflation.
It is crucial for individuals to understand the importance of interest rates, since they are a part of so many everyday business dealings. Every time someone takes out a personal loan, buys a bond, or uses a credit card, interest rates come into play. Interest rates are generally a part of any loan agreement, since the lender must be compensated for the risk of not receiving his money back from the lender. The nominal rate is the interest rate that the lender will actually receive from the borrower.
As an example, imagine that one party wants to borrow $50 US Dollars from another party. In return, the borrowing party agrees to pay back the money in a year at an interest rate of 10 percent. At the end of the year, if the borrower fulfills his part of the agreement, the lender will receive $55 USD. This total is reached by adding the repayment of the original $50 USD, also known as the principal of the loan, to 10 percent of that amount, or $5 USD. Since 10 percent is the nominal rate, the lender knows this will be his rate of return.
One problem with just relying on the nominal rate is that it is not an accurate reflection of the actual worth of the investment. Using the example above, it may seem that the borrower has received 10 percent on his original investment. But imagine that the inflation rate for the year was 7 percent. That means that the principal $50 USD has been devalued by $3.50 USD in that year.
For that reason, many investors who choose fixed income investments, like bonds, focus on the real interest rate. The real interest rate of an investment is determined by subtracting the rate of inflation from the nominal rate. In the above example, the inflation rate of 7 percent would be subtracted by the quoted rate of 10 percent, leaving a real interest rate of 3 percent. It would still be a positive investment for the lender if the borrower fulfills the agreement, but the lesser rate of return might not make it worth the risk.
