The real interest rate states the “real” rate that the lender receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate. If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is only 2%.
The real rate of interest could be said to be the actual mathematical rate at which investors and lenders are profiting from their loans. It is actually possible for real interest rates to be negative if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1% if the inflation rate is 4%. A comparison of real and nominal interest rates can therefore be summed up in this equation:
Real interest rate = Nominal interest rate – Inflation
Several economic stipulations can be derived from this formula that lenders, borrowers and investors can use to make more informed financial decisions.
Real interest rates can not only be positive or negative, but can also be higher or lower than nominal rates. Nominal interest rates will exceed real rates when the inflation rate is a positive number (as it usually is). But, real rates can also exceed nominal rates during deflation periods.