In Canada, interest rates have never been so low for such a long period of time. This news is fantastic for individuals that want to borrow money, but is bad news for individuals that have money to invest. To complicate matters further, these quoted interest rates are not the full story and many savers are actually losing money on their investments.
This article will explore the differences between the quoted and real interest rates. We’ll also look at how to determine what rates we’re really receiving.
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The Quoted Interest Rate
“Your savings account will pay a high interest rate of 0.8%!” – A Bank Advisor Somewhere
Likely, we’ve been told by our bank representative about their “amazing” interest rates. These quoted rates – formally known as nominal rates – are not the complete picture and in reality, you’re likely earning a lower interest rate than what you’ve been told.
The reason for this investment return gap is due to inflation.
The Real Rate
Inflation shapes the real returns that we receive from our investments. By definition, inflation is the increasing general price level in an economy over a period of time. In other words, what you get for your money will be valued less in the future. Similarly, your investment returns will be worth less in the future. To see how inflation impacts Canadians, The Bank of Canada has this calculator available. Also, you can read more about inflation here.
Calculating your Real Interest rate is actually quite simple. It’s your nominal interest rate subtracted by expected inflation. If you have a daily or monthly compounding rate, then you will have to convert it to its full nominal rate before you can calculate your real rate.
Real Rate = Nominal Interest Rate – Expected Inflation Rate
So for example, if your bank offers a “high interest” savings account that has a rate of 0.6% and if expected inflation stays at 1.3%, then your investments will have shrunk by .7%
Expected inflation is the inflation rate that will occur while you hold your investments or debt products. So, this is the future inflation rate. However, predicting the future economy is next to impossible, but one can estimate the future rate by understanding what the current inflation rate is and that the Bank of Canada targets an inflation rate of 2%. To find current inflation rate, simply go here and look for the “CPI Inflation Rate”.
We even take the estimated inflation rate a step further and try to determine what our personal inflation rate is. The CPI interest rate analyzes all regions of Canada and uses the costs of a typical Canadian household. In reality, inflation affects regions differently and households that stray from typical consumption patterns will have different inflation rates. This step is not necessary, but the concept is important to understand.
If one wants to take the analysis even further, they could also reduce their interest rate by what’s paid to income taxes.
How The Real Rate Affects You
It important to understand the concept of real interest rates when you make financial decisions and plans. Knowing this rate gives us an extra sense of clarity and understanding. Currently, most savings accounts have negative real interest rates and this is one of the reasons why investors have been piling their money into alternative investments like stocks and bonds
Beyond the effects on your investment, the real rate also affects us in our workplaces. If your annual raise percentage is less than expected inflation than you’ve technically received a pay cut.
Overall, understanding the concept of the real interest rate is vital during your financial adventure and it can help steer you towards the correct financial decisions.
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