# How to Calculate Real Interest Rate?

#### Table of Contents

If you are an investor trying to find out the real yield of an investment you made or you are a borrower who wants to know the real cost of paying back your loan, understanding how to calculate real interest rate can help you in that case. And this is what I’m going to cover in this article.

The concept of real interest rate is an extremely powerful tool for judging the value of any investment. This concept takes the impact of inflation into account and gives you an idea about the real nature of wealth growth. And whether you are a lender or a borrower, understanding this concept is extremely important to secure your financial future.

This article will explain to you what the real interest rate is and show you the formula for calculating it. On top of that, this article will also provide you with a step-by-step guide on how to calculate it along with practical examples which will help you to grasp the concept much more clearly and quickly.

# Real Interest Rate Formula

The formula of calculating the real interest rate is derived by dividing the sum of the nominal interest rate and one by the sum of the inflation rate during that period and one and then subtracting one from the resultant.

The real interest formula can be mathematically expressed as,

Real Interest Rate = {(Nominal Interest Rate + 1) ÷ (Inflation Rate + 1)} – 1

Alternatively, the real interest rate can also be calculated using the “Fisher Equation” as mentioned above in this article. This equation can be mathematically expressed as,

ir ≈ i – πe

Where,

i = Nominal Interest Rate

ir = Real Interest Rate

πe = Inflation Rate (Actual or Expected)

One thing to keep in mind while using the Fisher formula for calculating the real interest rate, it will give you an approximate value, not an absolute one.

# Real Interest Rate Definition

Real interest rate means an interest rate that is adjusted by subtracting out the current inflation rate entirely. This interest rate is used to lend cash between an investor or a lender and a borrower.

The concept of the real interest rate is particularly helpful to perceive the real yield to the investor or the borrower and the real cost of the fund to the borrower. This concept is the brainchild of Irving Fisher, one of the great monetary economists of the 20th century.

He is the one who first formulated a relationship between inflation and interest. This relationship is known as the “Fisher Equation”. More about that will be discussed in the latter portion of this article.

# How To Calculate Real Interest Rate?

To calculate the real interest rate, just follow the steps given below:

Step 1: First of all, find out the nominal interest rate of the investment. This is usually an annual rate of interest that is documented for any sort of investment.

Step 2: Secondly, identify the inflation rate during the period.

Step 3: Finally, put the values of the nominal interest rate and the inflation rate that you’ve identified in “Step 1” and “Step 2” respectively in the real interest rate formula mentioned above in this article. You can also use the Fisher equation to calculate the real interest rate but this will result in an approximate value.

# Practical Examples

Take a look at the following examples to get a clear idea about how to calculate real interest rate:

## Example 1

Let’s start with a simple problem. Assume Donald invested \$10,000 in a deposit fund that is long term. The annualized nominal interest rate offered for his investment 8% and the tenure is 5 years. Consider the inflation rate is predicted to be 4%. Now, calculate the real interest rate for Donald’s investment.

First, let’s try to identify the value for nominal interest rate and inflation rate in this problem.

Here, the nominal interest rate is 8% and the inflation rate is to be 4%. Now, let’s put these values in the first real interest rate formula mentioned above in this article.

Real Interest Rate = {(Nominal Interest Rate + 1) ÷ (Inflation Rate + 1)} – 1

= {(8% + 1) ÷ (4% + 1)} – 1

= {(0.08 + 1) ÷ (0.04 + 1)} – 1

= (1.08 ÷ 1.04) – 1

= 1.0385 – 1

= 0.0385

= 3.85%

Let us try to find out the real interest rate for this example using the Fisher equation:

ir ≈ i – πe

Here,

i or Nominal Interest Rate = 8%,

πe or expected Inflation Rate = 4%

So,

Real interest rate or ir ≈ 8% – 4% = 4%

Therefore, in this case, the real interest is calculated to be 3.85% using the first formula and 4% using the Fisher equation.

## Example 2

#### Let’s consider another hypothetical situation where Ivanka has a master’s degree in economics and now works for an International Company. Her company is now considering investing a lot of money in a country. The company has already decided on two potential candidate countries for their investment. Assume the countries are known as “Country A” and “Country B”. Below is the data that was collected by Ivanka.

Use the above information to calculate the real interest rate for both countries. Also, determine which country should the company select for their investment.

To calculate the real interest rate, we will need to find out the nominal interest rate and the inflation rate first. In the data table above, you can see there is a row named deposit interest rate. This will be your nominal interest rate for this example.

Now, as the inflation rate for both countries is not given, let’s calculate it using the data given in the table above.

Here, the inflation rate for “Country A” is going to be,

Inflation Rate = {(\$115,999,654.12 – \$111,259,552.54) ÷ \$111,259,552.54} × 100

= 4.26%

And for “Country B”, the inflation rate is going to be,

Inflation Rate = {(\$160,258,741.36 – \$155,987,123.45) ÷ \$155,987,123.45} × 100

= 2.74%

Now that we have the inflation rate and the nominal interest rate for both countries, let’s calculate the real interest rate.

In the case of “Country A”, the real interest rate will be,

Real Interest Rate = {(Nominal Interest Rate + 1) ÷ (Inflation Rate + 1)} – 1

= {(8% + 1) ÷ (4.26% + 1)} – 1

= 3.59%

Let’s try to calculate the real interest rate for “Country A” using the Fisher equation.

ir ≈ i – πe

Here,

i or Nominal Interest Rate = 8%,

πe or expected Inflation Rate = 4.26%

Therefore,

Real interest rate or ir ≈ 8% – 4.26% = 3.74%

Now, for “Country B”, let’s try to find out the real interest rate using the first formula,

Real Interest Rate = {(Nominal Interest Rate + 1) ÷ (Inflation Rate + 1)} – 1

= {(6.50% + 1) ÷ (2.74% + 1)} – 1

= 3.66%

By using the Fisher equation, the real interest rate for “Country B” is going to be,

ir ≈ i – πe

Here,

i or Nominal Interest Rate = 6.50%,

πe or expected Inflation Rate = 2.74%

Therefore,

Real interest rate or ir ≈ 6.50% – 2.74% = 3.76%

From the above calculation, we can see that no matter which formula we use, the real interest rate for “Country A” comes out to be a bit higher compared to “Country B”. So, it is better to invest in “Country A”.

# Use and Importance of Real Interest Rate

For investors or lenders, real interest rate bears a lot of significance. Understanding this concept is extremely important to them because it reflects the real nature of wealth growth after adjusting the interest rate by subtracting the inflation rate entirely.

You have to keep in mind that inflation erodes the actual value of cash. This is why it’s important to consider the potential effect of inflation before making any type of investment decision. And as a borrower, the concept of real interest rate will tell you exactly how much it costs to pay back your loan.

If the real interest rate is a positive value, the money you need to pay back is worth more in real terms as opposed to the amount you borrowed. And if it is negative, the money you need to pay back is less worth in real terms as opposed to the amount you borrowed.

# Conclusion

In this article, I’ve provided a step-by-step guide explaining how to calculate real interest rate along with some practical examples. Hopefully, through this article, I was able to clear all your confusion about this topic. Thanks for stopping by!

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