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What are interest rates and what is the difference between nominal and real interest rates?

25 May 2016

Interest is the cost of borrowing money, and the money you earn from your savings

Interest is the cost of borrowing money, and the money you earn from your savings. In other words, if you borrow money from a bank, the interest is what you pay for your loan. When you put your money in a savings account, interest is the return you receive on your savings from the bank.

Interest rates indicate this cost or return as a percentage of the amount you are borrowing or lending (since you are “lending” your savings to the bank).

Economists distinguish between “nominal” and “real” interest rates, but what is the difference between the two and why does it matter?

Nominal interest rate

The nominal rate of interest is the rate that is actually agreed and paid. For example, it’s the rate homeowners pay on their mortgage or the return savers receive on their deposits. Borrowers pay the nominal rate and savers receive it.

Real interest rate

It’s not only the nominal payment that is important to both borrowers and savers, but also how many goods, services or other things they could buy with that money. Economists call this the purchasing power of money. It usually decreases over time as prices rise due to inflation. Taking inflation into account shows the real cost of borrowing and the real return on savings. This is how it is calculated:

Real interest rate = nominal interest rate - inflation

How does it work in practice? Here’s an example

A saver who deposits €1,000 in an account for one year may get a nominal rate of interest of 2.5%, and so receive €1,025 in a year’s time. However, if prices increase by 3%, he or she will need €1,030 to purchase the same goods or services that, one year earlier, would have cost €1,000. This means that the real return will actually have been -0.5%. This is the real interest rate, and it is calculated by subtracting the rate of inflation (3%) from the nominal interest rate (2.5%).

Development of nominal and real interest rates in the euro area

The real interest rate varies depending on the nominal rate and the rate of inflation. For example, in the early 1980s even though the average nominal interest rate in the euro area was high, inflation was also high. As a result, the average real interest rate was low. The graph below shows the development of the average nominal and real interest rates on short-term bank deposits in euro area countries and the inflation rate since 1981.

Notes: percentages - Source: Eurostat, ECB, NCBs, ECB estimates