What is the difference between nominal and real interest rates?

Interest is the cost of borrowing money, and the money you earn from your savings. In other words, if you borrow money from a bank, the interest is what you pay for your loan. When you put your money in a savings account, interest is the return you receive on your savings from the bank.

Interest rates indicate this cost or return as a percentage of the amount you are borrowing or lending (since you are “lending” your savings to the bank).

Economists distinguish between “nominal” and “real” interest rates, but what is the difference between the two and why does it matter?

The nominal rate of interest is the rate that is actually agreed and paid. For example, it’s the rate homeowners pay on their mortgage or the return savers receive on their deposits. Borrowers pay the nominal rate and savers receive it.

However, it’s not only the nominal payment that is important to both borrowers and savers, but also how many goods, services or other things they could buy with the money. Economists call this the purchasing power of money. It usually decreases over time as prices rise due to inflation. Taking inflation into account shows the real cost of borrowing and the real return on savings. This is how it is calculated:

Real interest rate = nominal interest rate - inflation 


A saver who deposits €1,000 in an account for one year may get a nominal rate of interest of 2.5%, and thus receive €1,025 in a year’s time. However, if prices increase by 3%, he or she will need €1,030 to purchase the same goods or services that, one year earlier, would have cost €1,000. This means that the real return will actually have been -0.5%. This is the real interest rate, and it is calculated by subtracting the rate of inflation (3%) from the nominal interest rate (2.5%).

Source: European Central Bank

Published: 25 May 2016

​The above presentation was created for educational purposes.

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