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What is the Nominal Interest Rate?
The nominal interest rate is the stated or advertised rate of interest on a loan, deposit, or financial instrument, without adjusting for inflation. It reflects the percentage increase in money owed or earned over a period of time, but it does not account for changes in purchasing power. Nominal rates are commonly used in banking, lending, and fixed-income markets.
Definition
The nominal interest rate is the interest rate stated on a financial product, unadjusted for inflation, representing the gross rate of return or cost of borrowing.
Key takeaways
- Unadjusted for inflation: Reflects stated interest, not real purchasing power.
- Common in loans and savings: Used in bank products, mortgages, bonds, and credit.
- May differ from real interest rate: Real rate = nominal rate minus inflation.
- Influenced by monetary policy: Central banks target nominal rates.
- May include or exclude compounding: Depending on the calculation method.
Nominal interest rate formula
Basic nominal rate:
Nominal Rate = Real Interest Rate + Expected Inflation
Fisher equation approximation:
Real Interest Rate ≈ Nominal Rate – Inflation Rate
Examples
1. Loan example
A mortgage with a 10% stated interest rate has a nominal interest rate of 10%. If inflation is 6%, the real rate is roughly 4%.
2. Savings account
A bank advertises a 5% interest rate. This 5% is the nominal rate, regardless of inflation.
Why nominal interest rates matter
For borrowers:
- Determine borrowing cost.
- Affect monthly loan payments.
- Influence affordability of credit.
For savers and investors:
- Determine expected return.
- Influence portfolio allocation.
- Impact real rate of return after inflation.
For policymakers:
- Central banks adjust nominal rates to control inflation and economic activity.
Nominal vs. real interest rates
| Feature | Nominal Interest Rate | Real Interest Rate |
|---|---|---|
| Adjusted for inflation? | No | Yes |
| Shows | Stated return/cost | True purchasing-power change |
| Used for | Contracts, loans, ads | Economic analysis, investment decisions |
Factors influencing nominal rates
- Central bank policy rates
- Inflation expectations
- Economic growth
- Credit risk
- Financial market conditions
Limitations of nominal rates
- Misleading for long-term comparisons due to inflation.
- Does not reflect real purchasing power.
- May hide effective costs if compounding is not disclosed.
Related concepts
- Real interest rate
- Fisher equation
- Monetary policy
- Inflation
- Yield curve
- Annual percentage rate (APR)
Sources
- Federal Reserve – Interest Rate Policy: https://www.federalreserve.gov/
- International Monetary Fund: https://www.imf.org/
- OECD – Interest Rate Data: https://www.oecd.org/
Frequently Asked Questions (FAQ)
1. Why is the nominal rate important?
It shows the stated cost of borrowing or return on savings.
2. Can nominal rates be negative?
Yes. Some central banks have set negative nominal policy rates.
3. Who sets nominal interest rates?
Central banks influence them, but banks set rates for commercial products.
4. Is APR the same as the nominal interest rate?
APR often includes fees and compounding, while nominal rate may not.
5. How does inflation affect nominal rates?
Higher inflation expectations typically lead to higher nominal rates.
