# Understanding Real vs. Nominal Interest Rates

## Accounting Chapter Twelve

Conversely, callable bonds are attractive to issuers because they allow them to reduce interest costs at a future date should rates decrease. Moreover, they serve an important purpose to financial markets by creating opportunities for companies and individuals to act upon their interest-rate expectations. At the callable date, the issuer may “recall” the bonds from its investors. This simply means the issuer retires (or pays off) the bond by returning the investors’ money.

For example, if a customer owes the business money, the company may convert the account receivable into a note. The customer then becomes a borrower and pays interest, at a fixed rate, until the loan amount is paid.

The FDIC shows that the national average rate for money market accounts with deposits smaller than \$100,000 is 0.15%. But rates can be even higher if you choose to open a money market account at an online bank.

Amortized rates, common in car or home loans, are calculated so borrowers pay a larger amount of interest and a smaller amount of principal at the start of the loan. As time passes, the amount of principal paid each time increases, shrinking the principal and therefore the amount of interest charged on it. Thus, the amount of interest charged on the principal decreases over time while the interest rate stays the same. Borrowers will likely have a lower rate at the beginning of the loan, but the rate may increase over time.

## How can I still find a low rate?

A variable-rate loan is one where the interest rate on theloan balancechanges as rates in the market change, based on an index. As the interest rate changes, so does the monthly payment. Types of variable-rate loans include adjustable-ratemortgages, home equitylines of credit(HELOC), and some personal andstudent loans.

Interest provides the incentive for banks to lend money, so banks want to charge the highest interest rates they can. Money market accounts tend to have higher interest rates than checking or savings accounts.

is also called the stated, coupon, or nominal rate is the rate used to pay interest. Firms state this rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each interest period. When the Federal Reserve Bank makes a short-term loan to a financial institution, they apply an interest rate known as discount. Discount rates are based on cash flow analysis, which takes both the time value of money and the risk of future cash flow projections into account.

A variable-rate loan may be worth theinherent risksbecause it may save borrowers money on interest. From the lender’s perspective a variable-rate loan is far less risky than a fixed-rate loan, which could stick the bank with a low interest rate even if market rates are much higher.

Variable-rate loans are different from fixed-rate loans. The interest rate doesn’t change on fixed-rate loans, but it can become higher or lower on variable-rate loans.

If you borrow \$100 at a 6% interest rate, you can expect to pay \$6 in interest without taking inflation into account. The disadvantage of using the nominal interest rate is that it does not adjust for the inflation rate.

• The prime rate refers to the interest rate that commercial lenders use with their best – or most credit-worthy – customers.
• School loans and home loans are popular interest bearing notes.

As the interest rates on financial index change the lender may adjust the interest rate to follow the respective financial index. Some of the most common index used are the key index rateset by theFederal Reserveor theLondon Interbank Offered Rate(Libor).

## Recording Entries for Bonds

Since normal bonds have a fixed lifespan, investors can assume interest payments will continue until maturity and appropriately value those payments. Therefore, as rates fall, interest payments become more valuable over time and the price of the bond goes up. Despite the higher cost to issuers and increased risk to investors, these bonds can be very attractive to either party. Investors like them because they give a higher-than-normal rate of return, at least until the bonds are called away.

The prime rate refers to the interest rate that commercial lenders use with their best – or most credit-worthy – customers. This rate is based on the federal funds rate, or a daily rate that banks use when they borrow and lend funds with each other. School loans and home loans are popular interest bearing notes.

A nominal interest rate refers to the interest rate before taking inflation into account. The nominal interest rate is a simple concept to understand.

## market interest rate

There is no free lunch, and the higher interest payments received for a callable bond come with the price of reinvestment-rate risk and diminished price-appreciation potential. However, these risks are related to decreases in interest rates and make callable bonds one of many tools for investors to express their tactical views on financial markets. (For further reading on investment diversification practices, check out Achieving Optimal Asset Allocation). For this reason, when the Federal Reserve increased interest rates in March 2017 by a quarter percentage point, the bond market fell. The yield on 30-year Treasury bonds dropped to 3.02% from 3.14%, the yield on 10-year Treasury notes fell to 2.4% from 2.53%, and the two-year notes’ yield fell from 1.35% to 1.27%.

Some interest bearing notes are government issued, such as municipal bonds and treasury bills. These are investment vehicles that pay you a stated interest rate on your investment.

For example, Ally Bank offers 1% on a minimum \$25,000 balance and Capital One 360 offers 1.85% on a minimum \$10,000 balance. The real interest rate gives lenders and investors an idea of the real rate they receive after factoring in inflation. This also gives them a better idea of the rate at which their purchasing power increases or decreases.

### What is a market interest rate?

market interest rate. The prevailing rate of interest offered on cash deposits, determined by demand and supply of deposits and based on the duration (the longer the duration, the higher the rate) and amount (the higher the amount, the higher the rate) of deposits.