Nominal Interest Rate Details

Nominal interest rates are the interest rates lenders advertise before additional fees or adjustments. For a borrower, the nominal interest rate is the basic or minimum interest that a loan attracts before adjusting to match market factors.

While banks have the freedom to be flexible with their nominal interest rates, caps on these rates are placed by government or central banks. The Federal Reserve controls monetary policy by dictating the short-term nominal interest rates that central banks can set for smaller banks. Since small banks rely on lending money to make a profit, they usually take their cue from the nominal rates set by the central banks.

Other aspects that influence the nominal interest rates include monetary policies, money demand and supply, and policies by federal or national governments. Either way, the baseline is that the lower the nominal interest rates, the more borrowers take from their banks since they can afford it. For lenders, the nominal interest rate is a major aspect of marketing since it advertisers how affordable their loan services are.

Nominal Interest Rate Example

The nominal interest rate, also known as the money interest rate, is best understood through the Fisher Equation. Fisher’s equation explained that as prices change in the market, so should the return rates on financial instruments. Fisher’s law states that i = r + p.

In the equation, (i) represents the nominal interest rate, (r) the real interest rate, and (p) is inflation. The nominal interest rate equals the amounts of the real interest rate and inflation.

Compared to the real interest rate, the nominal rate is simple to understand. For example, say you borrow $100 at an interest rate of 5%. You would pay back $105. Since inflation is not taken into account with the nominal interest rate, the interest doesn’t change at all. Another example is when a bank advertises that new small business loans attract a 4% interest rate per year. The stated 4% is the nominal interest rate and tells customers how much more money they will remit as they repay their loans.

Nominal Interest Rate vs. Real Interest Rate

Another term often confused with nominal interest rate is real interest rate. The nominal interest rate is stated in the loan contract, but it doesn’t take into account any changes that might occur.

The real interest rate refers to the interest rate that does account for inflation. For a borrower or lender, the real interest rate is the best gauge for the cost of a loan since it factors in the inflation rates. Since there is no way to accurately predict inflation, real interest rates are considered fact-driven calculations.

To accurately calculate the real interest rate, subtract the nominal rate from the inflation rate. For instance, ABC bank has a nominal interest rate of 4% for three years. If the inflation rate within the specified time is 3%, then the real interest rate is 4%-3%=1%. Hence, the real interest rate is most important to investors than the nominal interest rate since it considers how purchasing power might change over time.