Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Real Interest Rate

What it is:

A real interest rate is an inflation-adjusted interest rate.

How it works (Example):

Let's say John Doe has a bond from Company XYZ that pays a 4% coupon. If the inflation rate is 3% per year, then the value of that coupon is 4% - 3% = 1%.

In many cases, the real interest rates on savings accounts are negative. For instance, if a savings account pays 1.5% per year but inflation is 3%, the saver is effectively losing money every year he has the money in the account. However, putting money in a savings account is better than putting it in a coffee can in the backyard, where it will lose the full 3% value every year due to inflation.

Why it Matters:

Inflation eats away at the value of every stream of cash flows, including salaries, pension payments, and coupon payments. Accordingly, it is important to consider the effects of inflation when making an investment that promises to provide a future stream of cash flows. After all, what is worth $1 today may not be worth $1 tomorrow if it is not invested.