How do you calculate the real interest rate?

2 How to calculate it

The simplest way to calculate the real interest rate is to use the Fisher equation, which states that the real interest rate is equal to the nominal interest rate minus the inflation rate. For example, if the nominal interest rate is 5% and the inflation rate is 2%, then the real interest rate is 3%. This means that your money will increase by 3% in real terms after one year, while the price level will increase by 2%. real interest rate = nominal interest rate - inflation rate Alternatively, you can use the exact formula, which accounts for the compounding effect of inflation. The exact formula is: real interest rate = (1 + nominal interest rate) / (1 + inflation rate) - 1 Using the same example, the exact real interest rate is:

real interest rate = (1 + 0.05) / (1 + 0.02) - 1
= 0.0294 or 2.94%        

As you can see, the exact real interest rate is slightly lower than the approximate one, because inflation reduces the effective return of the nominal interest rate.

3 How to use it

The real interest rate can help you evaluate different financial options and scenarios. For instance, you can use it to compare the returns of different investments, such as bonds, stocks, or savings accounts. You can also use it to assess the affordability and profitability of loans, such as mortgages, car loans, or student loans. Moreover, you can use it to understand the impact of monetary policy and economic conditions on your financial situation.

4 What to watch out for

When calculating and using the real interest rate, there are some factors that you need to be aware of. First, you need to use a consistent measure of inflation that matches the time period and currency of your interest rate. For example, if you are looking at a one-year interest rate in US dollars, you should use the annual inflation rate in US dollars as well. Second, you need to consider the expected or forecasted inflation rate, rather than the historical or current one, as the real interest rate reflects the future value of money. Third, you need to remember that the real interest rate is an approximation and may not capture all the nuances and variations of inflation and interest rate dynamics.

5 How to learn more

The real interest rate is an important concept that can help you make smarter financial decisions. However, it is not the only factor that you need to consider. You also need to take into account your risk tolerance, time horizon, financial goals, and market conditions. If you want to learn more about how to calculate and use the real interest rate, you can check out some online resources, such as articles, videos, podcasts, or courses, that cover the topic in more depth and detail. You can also consult a professional financial advisor or planner who can guide you through the process and offer personalized advice.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?