In economics, the term ‘interest rates’ has a few definitions which are competing. However, according to the Economics glossary, interest rate is the yearly price charged by a lender to a borrower in order for the borrower to obtain a loan. This is usually expressed as a percentage of the total amount loaned.
One might hear of all the different interest rates in the media around them. So the question that arises is, ‘How to differentiate between them?’ The very first thing one needs to understand is that there are not just a few but various (dozens or hundreds) of interest rates that vary according to their application. These rates can vary depending on the loan’s duration or the credibility and hence the involved risk factor of the borrower.
Primarily we have two interest rates, namely nominal interest rate and real interest rate.
Generally when we talk about interest rates, we are usually talking about the nominal interest rates. Nominal interest rates are those where the changes due to inflation in the rate are often not accounted for. The nominal interest rates often change with change in inflation rate since compensation has to be paid to lenders for 1) their delay in consumption and 2) the inflation, meaning that the amount of commodity a dollar buys now will not be same it buys the following year.
Real interest rate, on the other hand take inflation into account. It is approximately calculated as the result of subtracting inflation rate from nominal interest rate. Real interest rate is what the investors expect to receive after reducing the inflation.
Surprisingly, interest rates can go below zero. In theory nominal interest rates can be negative. This would imply that the borrowers will be paid interest by lenders for borrowing the money which is far from reality. However in reality, real interest rates do, on occasion, become negative.