Relationship Between Nominal & Real Interest Rate

by William Adkins
Savings bond interest appears minuscule but can become competitive.

Savings bond interest appears minuscule but can become competitive.

Creatas/Creatas/Getty Images

When you want to generate income rather than equity growth, a debt security like bonds is your most likely choice. However, all bonds are not the same. Bonds pay different interest rates and carry varying degrees of risk. Understanding the relationship between a nominal and a real interest rate is essential to assessing the investment potential of a particular security.


A nominal rate of interest can be defined in two ways. For most income-producing securities, the nominal rate is the interest rate you are quoted. For example, if you see a bond quoted at 5 percent, this is a nominal interest rate. One component of the nominal interest rate is an inflation premium. The real rate of interest is the nominal rate with the inflation premium factored out. Investors also use the term "nominal rate" to refer to the base rate for investments for which interest is compounded.


The real rate of interest is the nominal rate minus the expected inflation rate. However, the real rate itself has several components. First is the risk-free rate investors expect. This is the real rate you get on securities with negligible risk, like U.S. Treasury bonds. However, most bonds carry at least some risk of default, which is called credit risk. For these bonds, a risk premium is added to the risk-free rate to arrive at the real interest rate. Other factors, such as the maturity and liquidity of the bond, may also affect the real interest rate.


You can easily estimate the real interest rate. Look up the current rate of inflation. You’ll find current inflation rates on the U.S. Bureau of Labor Statistics’ Consumer Price Index Web page. Subtract the annual inflation rate from the nominal interest rate. For example, if a bond has a 5 percent nominal interest rate and the inflation rate is 3 percent, the real interest rate equals 2 percent


For investors, the difference between a nominal and real interest rate is of major importance. Suppose the inflation rate ranges around 3 percent. If you sell the bonds after a few years, the purchasing power of the dollars you are paid will have fallen by perhaps 20 percent. The inflation premium offsets the loss resulting from inflation.

Nominal Rate and Compound Interest

The interest on most bonds is paid directly to investors. However, some income investments, like bank certificates of deposit, accrue interest, thereby increasing the principal value of the security. The added money then earns more interest, called compound interest. The term "nominal interest" is sometimes applied to the base interest rate for such investments, and the compound interest rate is referred to as the actual interest rate. You can find the real rate of interest by factoring out the inflation premium from the nominal rate and adding in the difference between the CD's base rate and the compounded rate.

About the Author


Photo Credits

  • Creatas/Creatas/Getty Images
bibliography-icon icon for annotation tool Cite this Article