Real Interest Rate

The real interest rate is determined as the effective interest rate by subtracting the inflation rate from it. In other words, it can also be said that real interest rate is the amount by which the interest rate is higher than the inflation rate.

When the loan is lent out, both the lender and borrower are exposed to the risk of inflation volatility. The inflation rate over the loan period can never be known at the time of loan inception. Hence the concept of real interest rate is introduced. Here the real interest rate is approximated by subtracting the inflation rate from the nominal interest rate. The real interest rate can also be referred to as the growth rate of purchasing power obtained from an investment.

According to the concept of finance and economics, the lenders when give away loans and earn repayment at some future time, expect compensation relative to the time value of money. The lender needs to be compensated also for the risks of having less purchasing power from the capital when the loan is repaid. The risks that the lender has to face during the loan period are - regulatory risks, systematic risks and inflation risks. According to the systematic risk the lenders are exposed to the risks that the borrowers may default the loan, intentionally or un-intentionally. The regulatory risks may cause the lender to pay more taxes on the loan amount than what was estimated originally. The regulatory risks arise mainly due to changes in the taxation and law. According to the inflation risk, the lenders are in the risk that the money that is repaid would not have the same buying power as that of the money originally lent due to inflation.

Considering all the three types of risks and adding time value of money to that, the nominal interest rate is obtained. The real interest rates actually include the regulatory and systematic risks.

According to Fisher Equation, the relationship between the nominal interest rate, real interest rate and inflation is described as:

Real Interest Rate = Nominal Interest Rate - Inflation