Real Interest Rate

What it is

The real interest rate is the nominal (stated) interest rate adjusted for inflation. It represents the change in purchasing power an investor earns or a borrower pays. In short, it answers: “How much does my money really gain or lose in terms of goods and services?”

Formula

Real interest rate = Nominal interest rate − Inflation rate

Use the expected inflation rate for forward-looking decisions and the actual inflation rate for ex-post calculations.

Why it matters

• Measures true return: Nominal rates can be misleading when inflation is eroding value. The real rate shows the effective increase (or decrease) in purchasing power.
• Guides choices: Low or negative real rates encourage risk-seeking behavior (to seek higher returns), while high real rates favor saving and safer investments.
• Reflects time preference: Economically, it indicates how much people prefer current consumption over future consumption—higher real rates imply a stronger preference for consuming now.

Purchasing power and inflation

Purchasing power is the amount of goods and services a unit of currency can buy. Inflation is the general rise in prices over time, which reduces purchasing power. The Consumer Price Index (CPI) is a common measure of inflation used to adjust nominal rates to real rates.

Examples

• Positive real return: A certificate of deposit pays 4% nominal interest while inflation is 3% → real interest rate = 1%. Purchasing power increases by about 1%.
• Negative real return: A savings account pays 1% nominal interest while inflation is 3% → real interest rate = −2%. Purchasing power falls by about 2%.

Special considerations

• Expected vs. realized inflation: When planning investments or loans you must estimate future inflation. Those estimates can be wrong, so projected real rates are inherently uncertain.
• Fixed-income risk: Low nominal yields combined with rising inflation risk make real returns for bonds and CDs vulnerable; real returns can become negligible or negative.
• Policy and reporting: Central banks and statistical agencies publish inflation forecasts and ranges that investors use to form expectations, but actual inflation may differ.

How real rates affect investment returns

Inflation erodes nominal returns. For example, a 6% bond yield with 3% inflation delivers about a 3% real return. Investors should compare expected real returns across assets and consider inflation protection (e.g., inflation-linked bonds) if preserving purchasing power is a priority.

Practical tips

• Always consider inflation when comparing nominal yields.
• Use expected inflation for forward-looking planning and actual inflation when evaluating past performance.
• For capital preservation, consider instruments that adjust for inflation (TIPS or other inflation-indexed securities).
• Beware low-yield fixed-income investments in high-inflation environments—they can produce negative real returns.

Key takeaways

• The real interest rate equals nominal interest minus inflation and shows the true change in purchasing power.
• Expected inflation makes forward-looking real rates uncertain.
• Negative real rates mean your money loses purchasing power despite nominal gains.
• Real rates influence saving, borrowing, and investment behavior.

Bottom line

The real interest rate is the inflation-adjusted measure of the cost of borrowing and the yield on savings or investments. Evaluating real rates—rather than nominal rates alone—is essential for assessing true financial outcomes and preserving purchasing power.