Interest is an amount charged by lenders above and beyond the principal repayment amount of a loan. When analyzing interest rates, investors compare nominal interest rates against real interest rates to determine the future value of an investment made today. Understanding the difference between nominal and real interest rates and their application in analyzing investments can help you to choose the most favorable interest rate structures.
Interest Rate Applications
Interest is a concept than can be applied in a wide range of situations. Loans and mortgages require borrowers to pay regularly compounded interest. Bondholders receive annual interest payments from corporate or government bond-issuers. Credit arrangements, such as consumer credit cards, also charge interest on top of normal balances as an incentive for the credit card companies.
Nominal Interest Rates
Nominal interest rates, simply stated, are the interest rates contained in the original agreement, whether it be a loan, bond or other investment instrument. If, for example, you hold a bond that pays 10 percent interest annually, the nominal interest rate would be 10 percent. Defining a specialized term to represent an investment's stated interest rate may not make much sense at first, until you analyze the concept of real interest rates.
Real Interest Rates
Real interest rates are an adjusted figure that takes inflation and the number of interest-accumulating periods in the life of the investment into consideration. The theory behind real interest rates is based upon the time value of money. Since inflation and other forces continually change the value of money compared to market prices and foreign currencies, the value of the money that your current interest rate grants you today will not be the same in the future.
Calculating a real interest rate can give you a more realistic idea of the total value of your investment over time. Real interest rates can also shed light on the realistic cost of a loan over the repayment term. Real interest rates can help you to decide whether it is in your best interest to repay a loan early, for example, or to sell a bond rather than holding it to maturity.
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