Question

When we observe interest rates in the financial press, do we see nominal or real rates? Suppose you are in the process of applying for a 30-year fixed-rate mortgage. Which rate is more relevant to you? Why?

Now suppose you are planning to invest in a 30-year Treasury STRIPS. Which rate is more relevant to you? Why?

Answer 1

When an investor oberves the interest rates in the financial press, then such an investor looks at the nominal interest rate as the real interest rate observation is not general. Real interest rate refers to the rate of interest which does not have effect of inflation, that is, the rate from which the effect of inflation has been removed.

In an economy, the interest rates are shown at nominal level which includes the effect of inflation. Such interest rates are depicted in the general public document because showing real interest rate at the real time basis could be difficult as a matter of predicting inflation is not possible.

1. Suppose you are in the process of applying for a 30-year fixed-rate mortgage. Which rate is more relevant to you? Why?

If a borrower is going to apply for such a loan then he will first look at the rate prevailing in the market at which lending and investing is being done. This rate mostly accounts for many factors, however such rate is also nominal interest rate. And also such rate shall be most relevant for borrowing purposes because it will show to the investor that how much excess the bank is charging in excess of market rate. However, borrowing rate could be higher than market rate as a reason of creditworthiness of borrower and many other factors.

2. Suppose you are planning to invest in a 30-year Treasury STRIPS. Which rate is more relevant to you? Why?

If an investor is planning to invest in 30-year STRIPS (Separate trading of registered interest and principal securities), then only real interest rate shall be relevant for such an investor. Because the investor will look at the rate which he could earn from such investment after removing the effect of inflation.

The reason, an investor will look for such real interest rates is that he/she will be wanting to know that what rate of return could be earned from the given investment subject to inflation rate. As in case of investment, an investor also looks for real returns as inflation eradicates most of the returns, that is why after inflation return is most important.

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