Question

To a potential borrower, which would be more important, the nominal interest rate or the real interest rate? Explain your answer.

Short answer

The real interest rate would be more important to a potential borrower. It reflects the true cost of the loan, considering the effects of inflation on purchasing power. Understanding the real interest rate allows the borrower to accurately gauge the financial burden of their debt.

Step-by-step solution

Definition of Nominal Interest Rate

The nominal interest rate is the interest rate as stated in the loan contract and devoid of considering inflation. It does not take into account the purchasing power of the money borrowed over time. More often, this is the rate that banks advertise when they offer loans.

Definition of Real Interest Rate

The real interest rate is the interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or investor. In other words, the real interest rate is the nominal interest rate minus the inflation rate.

Importance in a Borrowing context

In a borrowing context, while the nominal interest rate might be the first thing people look at when choosing a loan, the real interest rate is actually more important. This is because the real interest rate gives the borrower an idea of how much the loan will actually cost in terms of real purchasing power by the time it is paid off, due to inflation.