Trading term
What is Real interest rate?
The real interest rate is what's left of a rate once inflation has taken its share, so it measures the growth in what your money can actually buy. It isn't nominal minus inflation: 5% against 3% inflation is 1.94%, not 2%.
An account paying 5% while prices rise 3% does not leave you 5% better off. You have 5% more dollars and each dollar buys less than it did. The rate on the statement is the nominal rate. What the money buys at the end of the year is the real rate, and that second number is the one that decides whether you gained anything.
Almost everyone subtracts, and subtracting is wrong. The right form divides: take one plus the nominal rate, divide by one plus inflation, then subtract one. At 5% and 3% that's 1.05 divided by 1.03, which gives 1.94%. Subtraction says 2%. The reason for the gap is that the interest you earned also gets spent at next year's higher prices, so inflation shrinks your gain as well as your original money.
At small numbers the error is tiny and the shortcut survives. At 5% against 3% inflation it's about six hundredths of a point. Push the numbers up and it stops being cosmetic: 16% against 12% inflation is really 3.57%, while the subtraction confidently reports 4%. Real rates also go negative, and they often have. An account paying 0.40% while prices rise 2% has a real rate of −1.57%, so the balance grows and buys less each year.
For example
You earn 5% on a deposit and prices rise 3% that year. Divide instead of subtracting: 1.05 ÷ 1.03 − 1 = 1.94%. Your money buys 1.94% more than it did, not the 2% the shortcut promised.
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Explore Premium →Why it matters to you
Every decision about money is really a decision about the real rate. A 16% deposit rate in a year when prices rose 12% is a worse deal than 3% in a year when prices barely moved. Nominal numbers are what get quoted, compared and remembered, and two of them from different decades can't be compared at all until you attach inflation to each one.
⚠ Nominal minus inflation is the wrong formula
It's taught everywhere as a shortcut and it's close enough at low rates that nobody notices. That's exactly what makes it dangerous. It's off in the flattering direction, so it always overstates what you made, and the error grows with the rate. Use it for a rough feel. Divide when you need the answer.