What is a Real Interest Rate?
A real interest rate is an inflation-adjusted interest rate.
How to Calculate a Real Interest Rate -- Formula & 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 do Real Interest Rates matter?
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.