Real Rate of ReturnDefined with Formula, Examples & vs. Nominal Rate

Written By:
Adiste Mae

When it comes to making an investment, we all want to know what we are getting out of it; whether the investor is a homeowner, a bank, or a business owner, they all want to know what an investment will be worth.

This is why an accountant devised a formula to calculate just that, the real rate of return of an investment.

This formula gives us the rate of return for any given investment and adjusts it for inflation.

This is also where the real rate of investment differs from the nominal rate of return, which is the rate of return but without any adjustments for external factors.

Let’s take a look at this critical investment concept, how to calculate it, and how it compares to the nominal rate of return.

The Real Rate of Return

The real rate of return is one of the most critical figures anyone needs to know when it comes to making an investment.

This crucial measurement tells us the annual percentage rate that is earned off of a given investment and adjusts it for external factors such as inflation.

This gives the actual amount of purchasing power that a given sum of money possesses over a span of time.

This provides us with a far better idea of what an investment is worth and can show how much of the return on an investment is a real return.

Of course, in addition to inflation, we have factors such as investment fees and taxes to consider, which can also have a huge impact on what an investor will actually earn.

This calculation will help you to decide between many similar-looking investment options.

How to Calculate the Real Rate of Return

The real rate of return is determined by taking your nominal interest rate and subtracting your inflation rate.

The formula for this is:

Real Rate of Return = (1+ Nominal Rate) / (1+Inflation Rate) -1

As you can probably see, this formula is pretty easy to use and understand but let’s look at a few examples so you can see how you might actually be able to use it in the real world.

Real Rate of Return Examples

Let’s say Mr. Business placed $10,000 in a savings account at his local bank at the start of the year.

The bank offers a 3% rate of return annually, and the rate of inflation throughout the year is 1%.

What is the real rate of return?

First remember the formula for real rate of return = (1 + Nominal Rate) / (1 + Inflation Rate) – 1

For our example this would be:

(1 + 0.03) / (1 + 0.01) – 1

= 1.03 / 1.01 – 1

= 0.0198 = 1.98%

Let’s consider another example that many people may come across in their lives.

Let’s assume that you save up $30,000 to make a down payment for a house, but you would like to have a little extra leftover to cover the closing costs.

So, you put the $30,000 you have earned aside into a savings account.

With 6% interest, you will have earned an extra $1,800 over the course of a year and have a total of $31,800 in your account.

But let’s assume that during that same year, the prices hiked by a combined 4% by the end of the year as the result of inflation.

This means that your down payment will now be $31,200.

Therefore, your real rate of return from the investment would be $31,800 minus the $31,200 of the now increased down payment.

This means that your real rate of return will be $600, which represents the actual purchasing power your money will have after accounting for inflation.

The Real Rate of Return and the Nominal Rate of Return

So, we have discussed the real rate of return, and as you have seen, we need to use the nominal rate of return in order to find it.

The reason is that the nominal rate of return is simply the rate of return without any adjustment for inflation.

This results in the nominal rate almost always being greater than the real rate of return, with the only exception being times of deflation, also known as negative inflation.

During times of extremely high inflation, the nominal rate of return can appear immensely high, and investments may appear amazing.

However, a high rate of inflation means that the actual profit from this investment or the real rate of return will actually be much lower and could result in a loss in particularly extreme cases.

The rate you will see advertised on common investment products is the nominal rate, and this is obviously valuable for understanding what it offers.

However, the real rate of return will give a fuller picture of how an investment has actually performed.

Issues With the Real Rate of Return

The biggest issue with the real rate of return is that it can only be accounted for after the events have already occurred.

This is because inflation for a specific period of time can only be found after that period has ended.

Other issues are that the real rate of return still is not a fully accurate rate of return because it fails to take into account additional costs such as investment fees and taxes.

These may be a significant expense and change the actual profit from an investment considerably.

Key Takeaways

So, what is the real rate of return?

It is the nominal rate of return adjusted for inflation.

It is found by taking your nominal interest rate and subtracting your inflation rate, and as a result, the real rate of return will be lower than the nominal rate except in cases of negative inflation.

However, this lower real rate of return represents a more accurate picture of the value of an investment and, as a result, is a valuable tool for investors.