What is the Real Interest Rate?

The real interest rate is the stated interest rate associated with an investment or loan, minus the inflation rate. This is a valuable concept when there is a significant amount of inflation, or when the inflation rate is projected to increase. However, it is inherently difficult to predict, given the many inputs that cause inflation to occur.

Impact of the Real Interest Rate on Investing

In cases where the inflation rate is expected to increase in the future, investors will be more likely to buy assets such as land, which tend to hold their value better than other investments. When large numbers of investors take this route, the price of land tends to increase.

Example of the Real Interest Rate

For example, an investor is evaluating whether to invest in a financial instrument that pays 5% per year. The current inflation rate is 3%, so the real interest rate associated with the prospective investment is the net of the two figures, which is 2%. If the inflation rate had instead been 6%, then the real interest rate would be negative 1%.

The Real Interest Rate When Inflation is Negative

In cases where the inflation rate is negative, the real interest rate is higher than the stated interest rate. Thus, when the inflation rate is -1% and the stated interest rate is 3%, the real interest rate is 4%.