A rate of interest that has been adjusted for inflation. For example, if the posted interest rate (nominal interest rate) is 4% and the inflation rate is 2%, the real interest rate is 2%.
When considering the value of money, the real interest rate makes more sense than the nominal interest rate. Consider an example: Your business loans another business or individual $100,000 for one year. The borrower agrees to pay back the loan, plus 4% interest at the end of the year, i.e. the borrower will pay your company $104,000 at the end of the year. If inflation had been 2% over the coarse of that year then, at that point in time one year later, a package of goods and services that would have cost your company $100,000 if you had bought it when the loan was made will now cost you $102,000. Thus, in terms of purchasing power, that 4% nominal interest will make you only roughly 2% wealthier at the end of the year, not 4% wealthier.
Contributed by: Managerwise Staff
See: nominal interest rate