The nominal interest rate is the rate stated on a loan or an investment before any adjustment for inflation. It is the percentage increase in money a borrower pays a lender for the use of the money borrowed, and it does not take inflation into account (Federal Reserve Bank of San Francisco, Dr. Econ). The same words carry a second and narrower sense, a stated annual rate quoted before the effect of compounding inside the year, which is worked through in effective interest rate formula.
Nominal Against Real
The real interest rate measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest, and the nominal rate equals the real rate plus the rate of inflation (San Francisco Fed, Dr. Econ). Advertised rates at banks and other financial service providers are typically nominal, so the figure on the offer is the money increase and not the purchasing power increase.
Borrow $100 for a year at 8% and repayment is $108, the $100 borrowed plus $8 in interest. If inflation runs 5% over that year, the lender earned only 3% in real purchasing power, or $3 on the loan (San Francisco Fed, Dr. Econ).
So one stated rate does not deliver one real return. A fixed rate on the note is set by the agreement and does not move afterwards, while the price level behind it does. Where the nominal rate sits below the rate of inflation, the lender takes back more dollars and less buying power than it started with.
Where a US Firm Meets a Nominal Interest Rate
The nominal rate is an input, not a result. The rate printed on the instrument fixes the cash the contract requires, and that stated figure is the coupon rate; the interest expense that reaches the financial statements follows the effective rate implied by what the debt actually raised, scheduled out in bonds payable.
Inflation-indexed debt is where the two rates come apart inside one instrument. Those rules apply to Treasury Inflation-Protected Securities, and under the coupon bond method stated interest is payable at a single fixed rate if each interest payment is determined by multiplying the inflation adjusted principal amount for the payment date by the single fixed rate, while the inflation adjustment is taken into account for each taxable year the instrument is outstanding and a positive one is original issue discount (eCFR, section 1.1275-7(b)(1), (d)(2)(ii), (d)(4)(i) and (d)(4)(iii)).
Because that fixed rate is applied to a principal amount that moves with inflation, a holder can carry income from the inflation adjustment in a year when no extra cash arrives.
What a Nominal Rate Is Not
A nominal rate is not an effective annual rate, because a rate quoted per annum says nothing about how often interest compounds inside the year, and the conversion between the two sits in effective interest rate formula. The same adjective does different work in the ledger, where a nominal account is one closed to zero at period end, set out in temporary accounting accounts.
Common Questions
The rate a loan or an investment states before any adjustment for inflation, which is why it says nothing about what those dollars will buy.
The nominal rate counts dollars and the real rate counts purchasing power, and the nominal rate equals the real rate plus the rate of inflation (San Francisco Fed, Dr. Econ).
There is no single one. The phrase names whatever rate a particular contract or instrument states, so the current nominal rate on a client’s note is the rate that note carries. For a market reading, comparable maturity Treasury securities give a way to estimate both nominal and real rates, one issue that is not adjusted for inflation and one that is (San Francisco Fed, Dr. Econ).
Usually you do not, because it is the rate the agreement states. Where it has to be derived it is the real rate plus the rate of inflation, or a periodic rate multiplied by the number of periods in a year, which converts to an effective rate in effective interest rate formula.
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