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Types of Interest Rates
It’s difficult to turn on the television or radio for a day without hearing the term “interest rates” at least once. However, bad finance is spread through the widespread misinformation that all too frequently dominated a conversation. This article aims to provide you with an understanding of what interest rates are and, more importantly, being able to reflect on the differences between the most popular types of interest rates variables. Having an understanding of interest rates is not only important to businesses and banks but increasingly important to consumers – having knowledge of this type of economics can help you to become a smart consumer.
We’re going to take a look through the different types of interest rates and what functions they serve.
What are Nominal Interest Rates?
This is the most basic type of interest rate – nominal simply refers to the stated rate that may be on your loan or bond. For example, if you have a 7% nominal rate then this means that you’ll consequently pay $7 for every $100 loaned. It’s also worth noting that this type of interest rate is also referred to as the coupon rate for fixed income investments – this is because the interest rate is guaranteed by the lender.
What are Real Interest Rates?
The real interest rate is slightly more complex than the nominal interest rate due to the influence of inflation. Put simply, inflation will affect the purchasing power for every dollar you own and therefore can have a significant effect on the payoff or maturity for a given amount of money. In other words, when you factor in the effect of inflation then you can determine the real interest rate as it reflects the real economy. The interest rate of the past is dependent on the existing rate of inflation at that time and not a future time.
As an example, let’s take a bond. This imaginary bond as a yield of 6% but the rate of inflation is 4%. This means that the real rate of inflation is only a mere 2%. Hence, this 2% real interest rate is the actual purchasing power investing capacity for a given amount of money at a given point in time. Let’s think of a second example: in this case, the rate of inflation is greater than that of the nominal interest rate. As you’ve probably guessed, this would return a negative real interest rate for that particular investment. If a bond has a yield of 4% with a rate of inflation at 5% then the real interest rate is -1%.
In conclusion: Nominal Interest Rate – Rate of Inflation = Real Interest Rate
What is an Effective Interest Rate?
This is the type of interest rate that takes the effect of compounding into consideration. As always, it’s best to look at an example to highlight how it works.
Let’s take a bond that pays a 6% yield on an annual basis how it compounds on a semiannual basis. This means that if the investor bond was worth $1,000 then they would earn $30 in interest after the first six months, giving them a total of $1,030. Then after the next 6 months, this same $1,030 would be subject to the interest rate therefore giving $30.90. This means that the total interest accrued is $60.90 which works out as an effective interest rate of 6.09%. This contrasts with the original yield of 6%.
Thus, when you take the compounding effect into consideration you can determine the effective interest rate for a given bond.
Why is this important?
It’s integral to understanding the difference between nominal, real and effective interest rates because it makes you, the consumer, more informed about investment decisions. If, for example, you were not aware of the effect of compounding and inflation then you could potentially make a really bad economic decision. Thus, this helps you to become a smart consumer as well as a smart investor. However, don’t assume that these decisions are always easy. It’s always worth consulting a financial advisor should you require professional advice. This is particularly true as rates of inflation change all the time and it may not be feasible for you to understand its long term implications.
Call us today at 424 225 2167 for help. One of our mortgage professionals will help you get the best possible loan solution for your situation. We’ll be with you every step of the process and not hand you off to someone else.