The Key Difference Between Nominal and Real Interest Rate

Nominal vs Real Interest Rate
Feature	Nominal Interest Rate	Real Interest Rate
Definition	The stated interest rate on a loan or investment, not adjusted for inflation.	The interest rate adjusted for the effects of inflation; reflects the true cost of borrowing.
Formula	Nominal Rate = Real Rate + Inflation Rate (approximate).	Real Rate = Nominal Rate − Inflation Rate.
Purpose	Indicates the actual rate charged or earned without considering purchasing power changes.	Shows the true return or cost after removing inflation effects.
Impact of Inflation	Does not account for inflation; may overstate returns or costs if inflation is high.	Adjusts for inflation; provides a more accurate measure of real earnings or expenses.
Use	Used in contracts, loan agreements, and financial statements.	Used for economic analysis and comparing purchasing power over time.
Example	If a loan has a 7% nominal interest rate and inflation is 3%, nominal rate is 7%.	Real interest rate would be approximately 4% (7% − 3%).
Effect on Borrowers	Borrowers pay the nominal rate regardless of inflation.	Real cost of borrowing depends on the inflation-adjusted rate.
Effect on Investors	Investors may see nominal returns eroded by inflation.	Real returns represent actual growth in purchasing power.