The Difference Betweeen Real Interest Rates And Nominal Interest Rates

If you have ever wondered why your interest rate calculations don't match those on your credit card or bank statement it may be because of the difference between real interest rates and nominal interest rates. This difference between interest rates is the inclusion of an inflation adjustment in the interest rate.

Inflation in this usage of the word, is reduction in the value of money over time. However, this should not be confused with 'inflation adjusted securities' which add rather than subtract the rate of inflation. Real interest rates are 'real' because they deduct inflation whereas nominal interest rates do not. It's not quite so simple however, as both nominal and real interest rates may also be compounded.

Interest rates can be deceptive because there are so many ways to calculate interest. To name a few, there are Annual Percentage Rates (APR), compounded interest rates, nominal interest rates, Effective Interest Rates (EIR) which use compounded interest in their calculation, and real interest rates. These interest rates may be either fixed or variable. Being aware of if your quoted interest rate is real or nominal in addition to the difference between these interest rates can be helpful in determining if you're really getting a deal on something instead of what just seems to be a deal.

How to calculate nominal and real interest

• Nominal interest calculation

The difference between nominal and real interest rates can also be illustrated in the calculations of the various forms of nominal and real interest rates. For example, calculating non-compounded nominal interest is the most conventional form of interest rate calculation and simply involves multiplying the amount by the interest rate i.e. $100 x 5% or .05 = $5. This $5 is not compounded however, and compounding interest is quite common in financial institutions.

• Compounded nominal interest

If the 5% is compounded monthly, the resulting balance will be more than $105 because of the compounding. For example the same $100 compounded monthly at a nominal interest rate for one year would be calculated by dividing $5 by 12 for .4166 cents first months interest. This .4166 cents is added to the $100 at the end of the first month for a balance of $100.4166. The second month's interest rate is then calculated using the same process, but with the new balance.

• Real interest rate calculation

Using the same example as above, a real interest rate deducts the rate of inflation from the nominal interest rate. Depending on the financial instrument, real interest rates may be adjusted monthly, bi-annually or periodically. For example, if the rate of inflation is recorded as 2% by the Federal Reserve Bank, and this is the rate used in calculating real interest rates, then 5%-2%=3% making the real interest rate 3%. If the real interest rate is calculated quarterly, i.e. every 3 months, this rate can change 4 times a year.

• Compounded real interest

Like nominal interest rates, real interest rates can also be compounded. The only difference between fixed compounded real interest rates and fixed nominal interest rates is the interest rate is likely to be lower for real interest rates. For example, using the $100 from above, the actual interest rate used is 3% not 5% so the first month's interest rate is calculated by multiplying $100 by .03 or 3% for an annual interest rate of $3 divided by 12 for .25 cents applied to the first month and 3% then applied to the balance of $100.25 and then divided by 12 for the second month's compounded interest.

Fixed vs variable nominal and real interest rates

Both real and nominal interest rates can also be fixed or variable. Fixed means the interest rate does not change and variable means the interest rate does change. When applied to nominal and real interest rates, no change to computing the above interest takes place if the interest rate is fixed. However, if the rate is variable, the rate of interest that is used when compounding varies.

To illustrate the affect of variable rates using the $100 from above both nominal and real interest can result in a difference from the first month and second month's interest. If the first month's interest is .25 cents but then the real interest rate is adjusted to 3.5% then the second month would be calculated by multiplying $100.25 by 3.5% or .035 and then dividing that amount by 12 for the second months interest i.e. $100.25 x .035= .2923 cents. If the rate had not been variable, the second month's interest rate would be the same as the example of compounded real interest above i.e. $100.25 x .03 =.2506.

Source: http://www.investopedia.com (Investopedia)

Wealth Accumulation: How to Save a Million Dollars

Millions of people have already saved a million or more dollars. According to the website of U.S. Senator's Bernie Sanders of Vermont, in 2009 7.8 million people were millionaires in the United States despite the economic environment. The characteristics of these people have, that would be millionaires don't have add clues to how to save a million dollars. If it were easy to save a million dollars, many more would have already done it, but how to save a million is not really a secret at all.

• Return on Investment (ROI)

Money is a resource like oil, labor and time. When money sits idly by doing nothing or isn't optimized for efficiency that resource incurs opportunity costs, becomes subject to inflationary pressure and lowers potential income. Making proper use of money such as through astute business and financial decision making can lead to returns on investment well into the double or even triple digits.

• Compounding, and Capital gains

Financial principles are the concepts behind economic thinking and day to day finance. Understanding principles like leveraged hedging, business cycle, capital appreciation, and compounding are stepping stones to implementing them in one's financial plan. Financial plans don't have to be complicated, and simple often is better, but either way a financial plan that correctly employs financial methods that work is essential to save a million dollars.

• Assets minus liabilities

Net worth is a financial concept that claims what goes out should be less than what comes in. If at any level this is not the case, saving a million dollars will likely not be possible in any conventional sense. The formula for net worth is easy to understand but hard to do, but is a way to save a million dollars.

• Vocational decisions

According to the U.S. Bureau of Labor Statistics, surgeons, engineers, scientists, lawyers and pilots all receive over $100K per year. Saving 50 percent of this amount every year without any ROI or compounding will save a million dollars after 20 years. Some millionaires may work hard toward their goal and simply earned their way to wealth through a high paying job or lucrative business.

• Financial instruments

A wide variety of financial instruments and methods exist to become wealth. When used correctly becoming a millionaire is only a matter of time, skill and know how. From annuities to zaitech, a wide range of investment and asset allocation methods exist that have made many millionaires. Keep in mind some financial instruments do involve considerable risk.

• Tax protection

Paying unnecessary taxes is a way to slow down wealth accumulation. To save a million dollars tax strategy can come in handy, and a number of legal tax shelters and financial techniques exist to reduce taxes thereby decreasing money paid out. For example, deferring unneeded income to future dates lowers taxes in the present.

• Use a financial plan

Sticking to a financial plan provides a good way to save a million dollars. For example, $999 USD that is added to by $99 per month for 60 years at 7% is equal to $1,031,070.37 with compounding once a year. If this interest accumulates and is contributed to within a traditional retirement account, tax will not have to be paid on it until withdrawal. Naturally, acquiring a high interest rate in as short a time period as possible is the challenge when using a savings method like this.

Knowing how to save a million dollars isn't necessarily difficult, implementing the steps that allow one to save a million dollars does require financial discipline, skill and usually effort. Limitations on people's income, high cost of living, financial obligations and unforeseen expenses can all drill holes into an otherwise solid financial plan. Overcoming these obstacles by utilizing one or more of the above steps will increase one's probability of saving a million dollars.

Sources:

1) http://bit.ly/daFpxy (Vermont Senator)
2) http://bit.ly/dWWXh (MoneyChimp)
3) http://bit.ly/cP6bBX (Bureau of Labor Statistics)