Real Interest Rate

Real Interest Rate. A percent figure that tracks your actual interest in any given conversation. Like, you bump into your old roommate and he starts talking about his foot polyp. Real interest rate: 15%. He starts talking about the time he was kidnapped by Basque nationalists while on a yacht with a Kardashian. Real interest rate: 95%.

The more famous version of Real Interest Rates has to do with finance. It tracks the rate of interest after subtracting the impact of inflation. Your friend wants to buy a purebred show pig for next year's county fair. It costs $1,000, but she doesn't have the cash on hand. So she borrows the money from you.

You agree to loan out the $1,000 for a year at 15% annual interest. That's the interest rate written into contract, the nominal rate.
The loan has to be paid back at the end of the year. Meanwhile, the inflation rate this year totals 5%...prices on everything are going up by an average of 5% during the 12 months. So you loan out $1,000 on January 1, and by the next December 31 you get $1,150 back. 15% nominal interest.

However, inflation eats into that profit. Every January, you like to buy a set of dinosaur-shaped novelty tea infusers to give away as New Year’s gifts. Last January, you could buy 100 tea infusers for $1,000...This New Year’s, those same 100 tea infusers cost $1,050. The 5% inflation at work.

When you loaned the money out, $1,150 could buy you 115 tea infusers. By the time you get the money back, $1,150 will only buy you about 110 tea infusers. And you'll have to throw in about $5 of extra money to get the 110th one. Your money buys less because of inflation. The real interest rate takes into account what you can buy with the money.

Here's the back-of-the-envelope way to calculate the real interest rate: take the nominal rate and subtract the rate of inflation. Bingo! What's left over is the real rate. The answer you get when you do this calculation is approximate. But it's an easy way to get close. So, you loan out $1,000 at 15% interest. But inflation that year is 5%. So 15 minus 5 is 10...real interest rate is 10%.

That checks out if you don't count money as money...but count it as what you can buy with the money. Like tea infusers. Last January 1, you loaned out enough money to buy 100 tea infusers. $1,000...back when an infuser cost $10 each. Now it’s December 31...you got back enough money to buy approximately 110 tea infusers. You got $1,150 but infusers cost $10.50.

That's 100 infusers worth of money last year turned into enough to buy 110 infusers this year. 100 to 110...10% return. Same as the real interest rate. When you're the lender, inflation eats into your profit. What should be a 15% return becomes a 10% return because 5% of your money gets slurped up by higher prices.

On the other end, though, it can be helpful. In the same deal, your friend is paying you back in currency that's 5% easier to get. When you're a borrower, inflation helps you pay off a loan easier. That's why lenders have to keep the inflation rate in mind when thinking about how to set their interest rates.

Let's look at it on a national scale. Greece is in trouble again. The country needs an $18 billion loan from the World Bank so it can afford the marble-cleaning bill for the Parthenon. The World Bank has to decide what interest rate to charge. Inflation has been running high lately. Last year it was 8%. Experts predict it will be about that same level for foreseeable future.

Meanwhile, the World Bank wants to secure a real interest rate of 5%. What does it do? Well, it wants a 5% real rate when inflation is running 8%. So it has to set the nominal rate at about 13%...5 plus 8 equals 13.