What does Nominal Interest Rate Mean?
What is nominal? Nominal is a finance and economics term that you’ll often find in many places. Depending on the context it can either mean to denote a fee that is lower than ‘real’ fees or can also refer to some kind of rate that is not treated (unadjusted) for inflation.
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An interest rate in a nutshell is an amount that the lender of the asset charges for the use of the said asset. The lender is fair to charge an interest rate because:
- After lending, they can’t use assets themselves or invest it somewhere else and that relates to the concept of opportunity cost. The bare minimum the lender expects to earn is the Risk-free rate because that’s the rate the lender can be sure of earning even without taking any risk.
- Positive Inflation Rate means that the money today is worth less than money tomorrow. If the lender is giving a loan to you, by the time he receives the principal back, it would be worth less than what it did when he made the initial loan.
- The borrower may default on the loan. Due to this, the lender must get paid something in order to compensate him/her for taking the risk. Naturally, there’s a positive relationship between the risk taken by the lender and the interest charged. Banks also charge you higher for having a lower credit score.
Different kinds of Interest Rates
The 3 kinds of Interest Rates:
- The nominal – Stated interest rate on a bond or a loan, unadjusted for inflation,
- Real – Taking into account the inflation rate and deducing that from Nominal to get Real Interest Rates.
- Effective Interest Rate – Taking into account the concept of compounding of money. The difference between Nominal and Effective Interest Rate increases with the number of compounding periods and is nil as the number of compounding periods is nil.
Interest Rates affect your daily life even though you might or might not be directly involved in making deposits or taking loans. If interest rates rise, bank loans cost more, which means that the businesses and people borrow less and demand falls and companies sell less. This leads to a shrink in the economy. On the other hand, if interest rates decrease, it gives a boost to the economy as people buy more, companies borrow and spend more, unchecked by real growth, it can also lead to inflation. The interest rate is a very important monetary policy through which the central banks try to achieve their economic goals.
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Author: Aman Aggarwal
About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.
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