Understanding Real Interest Rates

Understanding Interest Rates
Why Stuffing Cash in Your Mattress is a Bad Idea

   Interest rates are one of the most commonly advertised terms in the financial world. High interest savings accounts, low interest credit cards, high interest rate bond yields, low interest rate mortgages, the list goes on and on. But what does that actually mean for us? And how do interest rates fit into our personal finances?

   Interest rates fit into our finances in two ways, the cost of borrowing, and a return when investing. We'll look at the two here.

The Cost of Borrowing

   Interest is charged on the principal, the amount borrowed, and is usually expressed as an annual percentage rate (APR). If the interest is compounded, the interest is added to the previous principal, and interest is charged on the cumulative balance. This is essentially charging interest on interest, and is how many people end up drowning in vicious consumer debt.

   We’ll take a deeper dive into the debt side of personal finance next week. For this week, let’s look at the other side of the equation, lending money for interest income.

Interest as an Investment

   There are essentially 2 ways to generate interest income, lending money, and storing money. Almost all bank accounts provide a small amount of interest income. To increase that interest income, we can lock our funds into a bond or loan of some form. With innovations in FinTech, there are increasingly diverse options for lending outside the traditional realm of corporate and government bonds.

   Bank accounts provide an excellent way to hold emergency funds, and funds used for day-to-day needs. I recommend at least 2 bank accounts, one should be a high interest e-savings account for your emergency fund, and the second should provide you no fee transactions for your daily needs. Both these options provide you liquidity, the ability to quickly retrieve your money, but the trade-off is a lower interest rate. 

   To receive a higher interest rate, we can invest in bonds and loans. The money here is set aside for a pre-defined period of time, and to compensate for your loss of liquidity, the interest rate paid to you as income is higher. For example, a 5-year bond might pay you 3% interest, while a 20-year bond may pay you 5% interest. The extra interest income is paid to you to compensate you for using your money for a longer period of time.

Learning point: Interest Rates (income) increase to pay you for the use of your money for a longer time-frame.

   There exists one more consideration when looking at these interest rates. That is the difference between the Nominal Interest Rate, and the Real Interest Rate. The real interest rate takes into consideration inflation, and is more important to an investor than the nominal interest rate. They are tied to each other by inflation.

   Real Interest Rate = Nominal Interest Rate - Inflation Rate

   When evaluating your bank accounts and debt investments (bonds and loans), often the Nominal Interest Rate is stated. Your purchasing power, or your economic result will be impacted by the Real Interest Rate. 

   To see this in practice, let’s look at a few examples:

Understanding Interest Rates Examples

   As you can see, the real interest rate means you only make money when the Nominal (or Stated) Interest Rate is higher than the rate of inflation. Or put another way, the purchasing power of your dollar decreases over time. 

Learning Point: If the Nominal Interest Rate is lower than the Inflation Rate, you’re effectively losing money.

   For this reason, storing the extra cash under the mattress is a bad idea. Not to mention, mattresses these days are quite comfortable without the extra padding. 

Key Personal Finance Strategy Take-Aways

   Carrying a large balance in your regular bank account does you few favors, as Example 1 above shows, inflation is slowly eating that money up (even if it doesn’t look like it!). To ensure your emergency fund is available, and able to stretch as far in the future as it does now, I recommend a high interest account to counter some effects of inflation. And finally, when investing in debt or loans, to ensure that you have a profitable investment the Nominal (Stated) Interest Rate isn’t the right interest rate to look at. Instead, you need to calculate the estimated Real Interest Rate. 

   Don’t worry, we’ve thrown enough math at you for now. If you want speculation on what inflation rates will look like in the future, a quick google search will provide you professional estimates. 

   Equipped with this knowledge, as you engage in debt investing (bonds and loans), you’re ready to make a calculated decision!

Formula Recap:

Real Interest Rate = Nominal Interest Rate - Inflation Rate

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