# Nominal vs. Real Interest Rates: Formulas and Key Differences

> **Definition**
>
> A nominal interest rate is one that does not consider inflation.

## What Is Nominal Interest Rate?

Nominal interest rate refers to an interest rate that has not been adjusted for inflation. This contrasts with the real interest rate, which factors in the declining value of money.

Investors typically consider the real interest rate when looking for the most profitable places to invest their money. It is calculated by subtracting the inflation rate from the nominal interest rate.

[Nominal](https://www.investopedia.com/terms/n/nominal.asp) can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.

### Key Takeawys

*   Nominal interest rates do not account for inflation, unlike real interest rates, which adjust for it.  
    
*   Real interest rates are crucial for investors to avoid losing purchasing power due to inflation.  
    
*   During inflationary periods, central banks may set high nominal interest rates, which can impact spending negatively.  
    
*   The effective interest rate (APY) considers both fees and compounding, making it more relevant to borrowers and lenders than the nominal rate.  
    
*   The formula for calculating the real interest rate is: nominal rate minus inflation rate.

![Nominal Interest Rate: The interest rate before taking inflation into account.](https://www.investopedia.com/thmb/832v_A1ZiVKUH6nyvaElZ5FGK1U=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/nominalinterestrate.asp-v1-d2753bc58c7149cfa62d791447e9865c.png)

*It can also refer to the advertised or stated interest rate on a loan, without accounting for fees or compound interest. — Julie Bang / Investopedia*

## Basics of Nominal Interest Rate

[Central banks](https://www.investopedia.com/terms/c/centralbank.asp) set short-term nominal interest rates, which form the basis for other [interest rates](https://www.investopedia.com/terms/i/interestrate.asp) charged by banks and financial institutions. Nominal interest rates may be held at artificially low levels after a major recession to stimulate economic activity through low real interest rates, which encourage consumers to take out loans and spend money. However, a necessary condition for such stimulus measures is that [inflation](https://www.investopedia.com/terms/i/inflation.asp) should not be a present or near-term threat. In the U.S., the [federal funds rate](https://www.investopedia.com/terms/f/federalfundsrate.asp), set by the [Federal Reserve](https://www.investopedia.com/terms/f/federalreservebank.asp), is an example of a nominal rate.

During times of inflation, central banks usually set high nominal rates. They might overestimate inflation and keep nominal rates too high. High interest rates can harm the economy by discouraging spending.

> **Fast Fact**
>
> Nominal rates tend to be high during periods of high inflation.

Nominal interest rates differ from real and effective interest rates. [Real interest rates](https://www.investopedia.com/terms/r/realinterestrate.asp) tend to be important to investors and lenders, while [effective interest rates](https://www.investopedia.com/terms/e/effectiveinterest.asp) are significant for borrowers as well as investors and lenders.

Even though the nominal rate is stated for a loan, it's not usually what consumers pay. Consumers pay an effective rate, which changes due to fees and [compounding](https://www.investopedia.com/terms/c/compounding.asp). To that end, the [annual percentage rate (APR)](https://www.investopedia.com/terms/a/apr.asp) differs from the nominal rate, as it takes fees into account, and [annual percentage yield (APY)](https://www.investopedia.com/terms/a/apy.asp) takes both fees and compounding into account.

## How to Calculate Nominal Interest Rate

 You can calculate the nominal interest rate (n) for a set period if you know the effective interest rate:

n = m × \[ ( 1 + e) - 1 \]

Where:

*   e = effective rate
*   m = number of compounding periods

However, most borrowers typically want to know the effective rate, as the nominal rate is often the rate that is stated. The formula for effective interest rate (e) is:

e = (1 + n/m) - 1

Where:

*   n = nominal rate
*   m = number of compounding periods

For example, if a loan’s stated (nominal) rate is 8% and it’s compounded semiannually, then the effective interest rate (e) would be:

e = \[1 + 0.08/2\] - 1 = 8.16%

> **Fast Fact**
>
> Treasury Inflation-Protected Securities (TIPS) allow investors to preserve their savings without losing value to inflation.

## Comparing Nominal and Real Interest Rates

[Unlike the nominal rate, the real interest rate](https://www.investopedia.com/ask/answers/032515/what-difference-between-real-and-nominal-interest-rates.asp) takes the inflation rate into account. The equation that links nominal and real interest rates can be approximated as nominal rate = real interest rate + inflation rate, or nominal rate - inflation rate = real interest rate.

To avoid purchasing power erosion through inflation, investors consider the real interest rate, rather than the nominal rate. One way to estimate the real rate of return in the U.S. is to observe the interest rates on [Treasury Inflation-Protected Securities (TIPS)](https://www.investopedia.com/terms/t/tips.asp). The difference between the yield on a [Treasury bond](https://www.investopedia.com/terms/t/treasurybond.asp) and the yield on TIPS of the same maturity provides an estimate of inflation expectations in the economy.

For example, if the nominal interest rate offered on a three-year deposit is 4% and the inflation rate over this period is 3%, then the investor’s [real rate of return](https://www.investopedia.com/terms/r/realrateofreturn.asp) is 1%. On the other hand, if the nominal interest rate is 2% in an environment of 3% annual inflation, the investor’s [purchasing power](https://www.investopedia.com/terms/p/purchasingpower.asp) erodes by 1% per year.

## What Is the Difference Between Nominal and Real Interest Rates?

Nominal interest rates do not account for inflation, while real interest rates do. For example, in the United States, the federal funds rate, the interest rate set by the Federal Reserve, can form the basis for the nominal interest rate being offered. The real interest, however, would be the nominal interest rate minus the inflation rate, usually measured by the [Consumer Price Index (CPI)](https://www.investopedia.com/terms/c/consumerpriceindex.asp).

## Why Do Investors Care More About Real Interest Rates?

To avoid purchasing power erosion through inflation, investors consider the real interest rate rather than the nominal interest rate. One way to estimate the real rate of return in the United States is to observe the interest rates on Treasury Inflation-Protected Securities (TIPS). The difference between the yield on a Treasury bond and the yield on TIPS of the same maturity provides an estimate of inflation expectations in the economy.

## What Is Difference Between Nominal Rate and APY?

Annual percentage yield (APY) is the effective interest rate, which tends to be more relevant to borrowers and lenders. The consumer, usually the borrower, pays an effective rate that varies from the nominal (stated) rate based on fees and the effect of compounding. To that end, the effective rate (APY) is often higher than the nominal rate.

## How Do You Calculate the Effective Rate If the Nominal Rate Is Known?

The effective rate, which factors in compounding, can be calculated from the nominal rate, which is often the rate that is stated. The formula for effective interest rate (e) is:

e = (1 + n/m)^m - 1

(where n = nominal rate and m = number of compounding periods)

> **Article Sources**
>
> 1.  Federal Reserve Bank of San Francisco. “[U.S. Monetary Policy: An Introduction. Part 3: How Does Monetary Policy Affect the U.S. Economy?](https://www.frbsf.org/research-and-insights/publications/economic-letter/2004/01/us-monetary-policy-an-introduction-part-3-how-does-monetary-policy-affect-the-us-economy/)”
>     
> 2.  TreasuryDirect. “[Treasury Inflation Protected Securities (TIPS)](https://www.treasurydirect.gov/marketable-securities/tips/).”
>     
> 3.  U.S. Department of the Treasury. “[Daily Treasury Par Real Yield Curve Rates](https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_real_yield_curve&field_tdr_date_value_month=202507).”