Nominal interest rate definition
/What is the Nominal Interest Rate?
The nominal interest rate is the interest percentage stated in a contractual lending arrangement. This interest rate is not adjusted for the effects of inflation, so the return to the lender could be negative, if the inflation rate is higher than the nominal interest rate. Consequently, a lender must build inflationary expectations into the interest rate associated with a loan, or include a clause that adjusts the nominal interest rate for the effects of inflation.
Example of the Nominal Interest Rate
For example, if the inflation rate is 10% and the nominal interest rate on a loan is 8%, then the lender will experience a negative return of 2%. Conversely, if the inflation rate is only 2%, then the lender will experience a positive return of 6% on the loan.
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Nominal vs. Real Interest Rates
The nominal interest rate is the interest percentage stated in a contractual lending arrangement, while the real interest rate is adjusted for inflation and represents the true cost of borrowing or the true yield to the investor in terms of purchasing power. The key differences between the two concepts are as follows:
Impact of inflation. Nominal interest rates can be misleading during periods of high inflation because they may appear to offer a good return, while the real value of returns may be much lower. Conversely, real interest rates account for inflation, providing a clearer picture of the actual gain or cost in terms of real money value over time.
Use in financial analysis. Nominal interest rates are only used for short-term financial analyses where there is not enough time for inflation to have much of an impact. Real interest rates are used for longer-term analyses, since these rates incorporate the effects of inflation.