Nominal Interest Rate

Published Jan 8, 2023

Definition of Nominal Interest Rate

The nominal interest rate is the rate of interest that is stated on a loan or other financial instrument without taking into account the effect of inflation. That means it is the rate of interest that is stated in the contract and does not reflect the real rate of return that the borrower or investor will receive. It can be calculated as the real interest rate + the projected inflation rate.

Example

To illustrate this, let’s look at a loan with a nominal interest rate of 5%. That means the borrower will have to pay back the loan plus 5% interest. However, if the inflation rate is 3%, the real rate of return for the borrower is only 2% (i.e., 5% – 3%). That means the borrower will only receive a real return of 2% after taking into account the effect of inflation.

Why Nominal Interest Rate Matters

The nominal interest rate is an important concept for both borrowers and lenders. For borrowers, it is important to understand the real rate of return they will have to pay on their loan. For lenders, it is important to understand the real rate of return they will receive on their investment. That means it is important to take into account the effect of inflation when calculating the real rate of return. Otherwise, the borrower or lender may end up with a worse real interest rate (i.e., lower return) than expected.