Table of Сontents
- What Is a Real Interest Rate?
- Real Interest Rate Formula & How To Calculate
- Real Interest Rate & The Cost Of Capital
- Real Interest Rate & Demand For Goods and Services
- What The Real Interest Rate Tells You
- Bottom Line
Inflation affects interest rates on investment securities as well as borrowing costs, which reduces the buying power of the currency. Investors would do well to comprehend and compute “the real interest rate,” which is the rate of return on an investment adjusted for inflation.
What Is a Real Interest Rate?
The interest rate an investor obtains or anticipates receiving on an investment after accounting for inflation is known as the real interest rate. As an illustration, if an investor is thinking about buying a bond with a nominal yield of 4% and the inflation rate is 3%, the real interest rate on the bond is 1%.
Real interest rates can be negative when nominal rates on savings and investment instruments are historically low and inflation is higher than its historical average of around 3.2 percent. For instance, in March 2022, when nominal interest rates on Treasury bonds were about 2.5 percent, the rate of inflation hit 8.5 percent, making the real interest rate -6.0 percent.
Real Interest Rate Formula & How To Calculate
By deducting the present or anticipated rate of inflation from the nominal interest rate on an investment, the real interest rate formula may be derived. The rate before accounting for inflation is known as the nominal rate, often known as the nominal yield. The Consumer Price Index, or CPI, is a commonly used indicator of inflation (bls.gov).
The nominal interest rate minus the actual or anticipated rate of inflation equals the real interest rate.
Real Interest Rate & The Cost Of Capital
As real interest rates rise, a company’s cost of capital—the price it must pay for debt or equity financing—also rises. Equity financing is more expensive than debt financing due to higher projected rates, greater inflation, and higher expected rates combined with equity financing.
Observation: A company may compute its cost of capital to determine the minimum return required for a new project. The cost of debt for a corporation will go up if financial institutions or bondholders are charged higher interest rates. When it comes to equity financing, the real interest rate, which takes inflation into account, will often raise the risk-free rate of return, which is a crucial component in calculating the cost of capital.
Real Interest Rate & Demand For Goods and Services
Interest rates and consumer demand for goods and services typically go hand in hand. Thus, consumer demand often decreases when interest rates rise, although demand might grow as rates plummet. Part of the reason for this is that rising rates make borrowing more expensive for both individuals and corporations. The demand for goods and services may also be influenced by the real interest rate, which takes inflation into account.
Due to the fact that increasing interest rates raise the cost of borrowing, consumers gradually cut down on borrowing in an environment where interest rates are rising. Inflation may also be high and peaking in this scenario. When fixed-income assets are adjusted for inflation, the real interest rate is lower, which can undermine consumer confidence and, in turn, further reduce demand for goods and services.
What The Real Interest Rate Tells You
The interest rate an investor is earning on an investment after accounting for inflation is known as the real interest rate. For instance, if inflation is 3% and a bond is paying 4% interest, the actual interest rate is 1%. When inflation is strong and investment yields are low, the real interest rate can be very evident and even turn negative.
Increase vs. Decrease in the Real Interest Rate
An increase in real rates of return is advantageous to investors since they represent the nominal rate after accounting for inflation and the real interest rate. A decline in real rates, however, is often undesirable for investors as it results in lesser returns.
For borrowers, it’s the exact reverse. Higher real interest rates boost the cost of capital for firms that utilize debt financings, such as selling bonds, to obtain money, as well as the cost of borrowing on a variety of loan instruments, including mortgages and credit cards for consumers.
Bottom Line
Investors, consumers, and companies are impacted by the real interest rate, which is the nominal rate adjusted for inflation. Fixed-income assets will yield more with higher rates, but the economy will usually grow more slowly due to the increased borrowing costs. Although lower rates mean lower investment yields, they also mean reduced borrowing costs, which will eventually boost the economy.
