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“Interest rate” is one of the most common phrases you’ll hear in the finance world. It is on everything and you could say it’s one of the most prominent and fundamental principles of finance. Of course as a regular consumer, some interest rates may not be as relevant to you, however, they are still an important aspect to be keeping in mind.
The first thing to keep in mind about interest rates is there are many types of interest rates. You may hear terms like real interest rate or effective interest rate and you may be lost as to what they are. Don’t worry, we’ll cover these and more.
The second thing to make note of is the biggest differences between each interest rate we’ll discuss is based on many key economic factors. While it seems trivial to the average consumer, retailers, and banking institutions have been making hundreds of billions of dollars over many years due to these interest rates. It’s been lingering around due to many people being ignorant of these rates.
So those who understand interest rates, particularly nominal and real interest rates, can take a massive step in becoming smarter investors as well as consumers.
Let’s first cover what nominal interest rates are. They are the simplest to understand in the sense that they are literally the stated interest rate on a bond or a loan. What the nominal rate means is this is the rate that is used to determine how much the borrower will pay to the lenders in order for them to use the lent money. You might also hear the term “coupon rate” which is the exact same thing. Why is it called a coupon rate at times you might ask? Simple. The issuer of bonds initially stamped the interest rates on coupons that were redeemed by bondholders long ago.
The second interest rate you’ll find a lot of is the real interest rate. This particular interest rate is no simple nominal rate, but the concept is still easy to grasp. You see the nominal rate has a massive flaw and that is that it doesn’t consider inflation. Just like inflation causes prices for goods and services to rise, so too does it raise a lender or investors purchasing power as well. This means that both parties involved won’t be able to buy the exact same thing today as they could later on.
As far as the purpose of this rate it represents the “real” rate that a lender or investor actually receives once inflation is accounted for. In other words, it’s the interest rate that exceeds the current inflation rate. For example, if you purchase a bond at 6% nominal interest rate and the inflation rate at the time was 4%, your real rate would be 2%.
The last of the interest rates you’ll need to know is the effective interest rate. This is like the real interest rate in the sense it accounts for something. In this case, the effective interest rate considers compound interest which is interest on interest. Basically, the effective interest rate is based on the number of compounding periods there are within a specific period of time (normally a year).
Understanding these rates is crucial in the financial world and they do factor in a number of financial decisions. If you want to be an investor, you need to be familiar with them.