Real Interest Rate

Interest rates are usually quoted in nominal terms, but inflation reduces what money can buy. The real interest rate removes the effect of rising prices so you can see the true gain or cost.

A simple approximation is to subtract inflation from the nominal rate. If a savings account pays 5% and inflation is 3%, the real interest rate is about 2%. Your balance grows by 5%, but because prices have risen by 3%, you can buy only about 2% more than before. The precise figure is slightly lower, about 1.94%, but the simple subtraction is close enough for most purposes.

Real interest rates can be negative. If savings pay 2% while inflation is 5%, the real rate is about −3%, meaning savers lose purchasing power even as their balances grow.

For borrowers, the effect is reversed. High inflation reduces the real burden of fixed-rate debt, because repayments are made with money that is worth less. Central banks watch real interest rates closely, because they shape decisions to save, borrow and invest.