What Are the Applications of Nominal Interest Rates?

Helen Akers

The term "nominal interest rates" is generally used in one of two ways: to describe the rate of return on an investment or the amount of interest charged on a loan. It can be thought of as the quoted interest rate. If a bank states that it charges 6 percent interest on a 15 year mortgage, 6 percent is the nominal interest rate. Likewise, the nominal rate for a savings account is the additional interest it yields as a percent of the total saved. Nominal interest rates are not adjusted for inflation.

Nominal interest rates can be influenced by an individual's credit history.
Nominal interest rates can be influenced by an individual's credit history.

Many individuals use nominal interest rates to figure out how much they will earn on an investment. For instance, if someone makes an initial deposit amount of $1,000 US Dollars (USD) that earns 10 percent annual interest, he will gain $100 USD. The interest payment is added to the initial deposit, bringing the account balance to $1,100 USD. In the second year, the investor continues to earn 10 percent interest on the new balance, resulting in additional interest earnings of $110 USD, and bringing the total to $1,210 USD.

An issue with using nominal interest rates to calculate earnings is that inflation is not taken into account. Assuming an inflation rate of 5 percent, the real earnings in the above example would be reduced to $50 USD in year one and $52.50 USD in year two. Since inflation reduces the spending power of money, the value of $1 USD decreases over time. It takes more money to obtain the same types of goods, which is why relying on the nominal interest rate might be misleading.

If for some unlikely reason inflation remains at zero, nominal interest rates would be a correct estimate of earnings. One of the reasons why some investors take larger risks with the stock market is to obtain a high nominal interest rate. This high rate helps offset the cost of inflation in the long run. For example, a stock portfolio that yields an average return of 15 percent over 30 years is considered normal or adequate.

Nominal rates also reflect the cost of borrowing. If a consumer takes out a car loan for $10,000 USD and pays $500 USD in interest payments the first year, the nominal rate is 5 percent. The lender assumes the risk of inflation outpacing the interest rate, as well as the risk of payment default. In the United States, nominal interest rates can be influenced by the costs of borrowing from the Federal Reserve, macroeconomic conditions, and an individual's credit history.

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