Legal Definitions - real rate

The real rate refers to the actual return on an investment or the true cost of borrowing money, after accounting for the impact of inflation. While a nominal rate is the stated interest rate without any adjustments, the real rate provides a more accurate picture of the change in purchasing power over time. It helps individuals and businesses understand the true economic gain or cost, as inflation erodes the value of money.

• Example 1: Savings Account Growth

  Imagine you deposit $5,000 into a savings account that offers a 2.5% annual interest rate (the nominal rate). Over the same year, the inflation rate is 2%. While your account balance grows by 2.5% in dollar terms, the cost of goods and services has also increased by 2%.

  This example illustrates: Your money's nominal growth is 2.5%, but its real rate of return is only approximately 0.5% (2.5% - 2%). This means your purchasing power, or what your money can actually buy, has only increased by half a percent, not the full 2.5% stated by the bank.

• Example 2: Mortgage Loan Cost

  A homeowner takes out a 30-year mortgage with a fixed interest rate of 6% (the nominal rate). If the average annual inflation rate over the life of the loan turns out to be 3%, the homeowner is repaying the loan with money that is gradually worth less in real terms.

  This example illustrates: Although the homeowner pays a 6% nominal interest rate, the real rate of interest they are effectively paying is closer to 3% (6% - 3%). This is because the purchasing power of the dollars they repay decreases over time due to inflation, making the "real" burden of the debt less severe than the nominal rate suggests.

• Example 3: Business Investment Return

  A company invests in new machinery, expecting a 7% annual return on its investment (the nominal return) over five years. However, during that five-year period, the average annual inflation rate is 4%.

  This example illustrates: The company's investment yields a 7% nominal return, but to understand the actual increase in the company's wealth and purchasing power, they must consider inflation. The real rate of return on their investment is approximately 3% (7% - 4%), indicating the true economic benefit after accounting for the rising cost of other goods and services.