he term “ interest rate ” is one of the most commonly used phrases in consumer finance and fixed income investments . Of course, there are several types of interest rates: real, nominal, effective, annual and so on. The differences between the various types of rates, such as nominal and real, are based on several key economic factors. But while these technical variables may seem trivial to the uneducated, lending institutions and retailers have been taking advantage of the public’s general ignorance of these distinctions to rake in hundreds of billions of dollars over the years. Those who understand the difference between nominal and real interest rates have therefore taken a major step toward becoming smarter consumers and investors. Nominal Interest Rate The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. This type of interest rate is referred to as the coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders. The nominal interest rateis in essence the actual monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them. Real Interest Rate The real interest rate is slightly more complex than the nominal rate but still fairly simple. The nominal interest rate doesn’t tell the whole story, because inflationreduces the lender's or investor’s purchasing power so that they cannot buy the same amount of goods or services at payoff or maturity with a given amount of money as they can now. The real interest rate is so named because it states the “real” rate that the lender or investor receives after inflation is factored in ; that is, the interestrate that exceeds the inflation rate. If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is only 2%. The real rate of interest could be said to be the actual mathematical rate at which investors and lenders are increasing their purchasing power with their bonds and loans. It is actually possible for real interest rates to be negative if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1% if the inflation rate is 4%. A comparison of real and nominal interest rates can therefore be summed up in this equation: Nominal interest rate – Inflation = Real interest rate Several economic stipulations can be derived from this formula that lenders, borrowers and investors can use to make more informed financial decisions. Real interest rates can not only be positive or negative, but can also be higher or lower than nominal rates. Nominal interest rates will exceed real rates when the inflation rate is a positive number (as it usually is). But real rates can also exceed nominal rates during deflation periods. A hypothesis maintains that the inflation rate moves in tandem with nominal interest rates over time, which means that real interest rates become stable over longer time periods. Investors with longer time horizons may, therefore, be able to more accurately assess their investment returns on an inflation-adjusted basis. Effective Interest Rate One other type of interest rate that investors and borrowers should know is called the effective rate, which takes the power of compounding into account . For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who invests $1,000 in this bond will receive $30 of interest after the first 6 months ($1,000 x .03), and $30.90 of interest after the next 6 months ($1,030 x .03). The investor received a total of $60.90 for the year, which means that while the nominal rate was 6%, the effective rate was 6.09%. Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific time period. Note that the rules pertaining to how the AER on a financial product is calculated and advertised are less stringent than for the annual percentage rate (APR). Applications The chief advantage to knowing the difference between nominal, real and effective rates is that it allows consumers to make better decisions about their loans and investments. A loan with frequent compounding periods will be more expensive than one that compounds annually. A bond that only pays a 1% real interest rate may not be worth investors' time if they seek to grow their assets over time. These rates effectively reveal the true return that will be posted by a fixed-income investment and the true cost of borrowing for an individual or business. Investors who seek protection from inflation in the fixed-income arena can look to instruments such as Treasury Inflation Protected Securities (TIPS), which pay an interestrate that is indexed to inflation. In addition, mutual funds invest in bonds, mortgages and senior secured loans that pay floating interest rates that periodically adjust with current rates. Conclusion Interest rates can be broken down into several subcategories that incorporate various factors such as inflation. Smart investors know to look beyond the nominal or coupon rate of a bond or loan to see whether it really fits their investment objectives. Consult your financial advisor if you need professional advice on interest rates and investments that keep up with inflation.
Once a bond is issued the issuing corporation must pay to the bondholders the bond's stated interest for the life of the bond. While the bond's stated interest rate will not change, the market interest rate will be constantly changing due to global events, perceptions about inflation, and many other factors which occur both inside and outside of the corporation. The following terms are often used to mean market interest rate: effective interest rate yield to maturity discount rate desired rate When Market Interest Rates Increase Market interest rates are likely to increase when bond investors believe that inflation will occur. As a result, bond investors will demand to earn higher interest rates. The investors fear that when their bond investment matures, they will be repaid with dollars of significantly less purchasing power. Let's examine the effects of higher market interest rates on an existing bond by first assuming that a corporation issued a 9% $100,000 bond when the market interest rate was also 9%. Since the bond's stated interest rate of 9% was the same as the market interest rate of 9%, the bond should have sold for $100,000. Next, let's assume that after the bond had been sold to investors, the market interest rate increased to 10%. The issuing corporation is required to pay only $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder is required to accept $4,500 every six months. However, the market will demand that new bonds of $100,000 pay $5,000 every six months (market interest rate of 10% x $100,000 x 6/12 of a year). The existing bond's semiannual interest of $4,500 is $500 less than the interest required from a new bond. Obviously the existing bond paying 9% interest in a market that requires 10% will see its value decline. Here's a Tip An existing bond's market value will decrease when the market interest rates increase .The reason is that an existing bond's fixed interest payments are smaller than the interest payments now demanded by the market. When Market Interest Rates Decrease Market interest rates are likely to decrease when there is a slowdown in economic activity. In other words, the loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced. Let's examine the effect of a decrease in the market interest rates. First, let's assume that a corporation issued a 9% $100,000 bond when the market interest rate was also 9% and therefore the bond sold for its face value of $100,000. Next, let's assume that after the bond had been sold to investors, the market interest rate decreased to 8%. The corporation must continue to pay $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder will receive $4,500 every six months. Since the market is now demanding only $4,000 every six months (market interest rate of 8% x $100,000 x 6/12 of a year) and the existing bond is paying $4,500, the existing bond will become more valuable. In other words, the additional $500 every six months for the life of the 9% bond will mean the bond will have a market value that is greater than $100,000. Here's a Tip An existing bond's market value will increase when the market interest rates decrease . An existing bond becomes more valuable because its fixed interest payments are larger than the interest payments currently demanded by the market. Relationship Between Market Interest Rates and a Bond's Market Value As we had seen, the market value of an existing bond will move in the opposite direction of the change in market interest rates. When market interest rates increase, the market value of an existing bond decreases. When market interest rates decrease, the market value of an existing bond increases. The relationship between market interest rates and the market value of a bond is referred to as an inverse relationship. Perhaps you have heard or read financial news that stated "Bond prices and bond yields move in opposite directions" or "Bond prices rallied, lowering their yield..." or "The rise in interest rates caused the price of bonds to fall." If you were the treasurer of a large corporation and could predict interest rates, you would... Issue bonds prior to market interest rates increasing in order to lock-in smaller interest payments. If you were an investor and could predict interest rates, you would... Purchase bonds prior to market interest rates dropping . You would do this in order to receive the relatively high current interest amounts for the life of the bonds. (However, be aware that bonds are often callable by the issuer.) Sell bonds that you own before market interest rates rise . You would do this because you don't want to be locked-in to your bond's current interest amounts when higher rates and amounts will be available soon. 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