Welcome to the world of interest rates, where the key players —the Discount Rate, Federal Funds Rate, Real Interest Rate, and Nominal Interest Rate, are the four unique interest rates that harmonically shape our financial world. So, what are interest rates? Say you borrowed 50 dollars from your friend Sally, and she says, “Pay me back anytime you want but there is a 5% interest rate with each passing month.” You pay back Sally after three months and end up giving her $57.50, even though you only borrowed $50. This is due to the 5 percent interest rate that is tacked on with each month. To put it in simpler terms, it is the added amount that you have to pay back when you are borrowing money. This article will explore the four types of significant interest rates: Discount Rate, Federal Funds Rate, Real Interest Rate, and Nominal Interest Rate.
The Discount Rate
The discount rate is the rate charged to financial institutions and commercial banks for short-term loans. The discount rate can be used by firms and investors for anticipated investments. Commercial banks can borrow money for short-term use by the market-based interbank rate, or they can borrow from the Federal Reserve Bank for short-term needs, which is called the discount window. The Federal Reserve maintains a discount rate for the discount window. Lastly, the discount window is usually used by troubled banks and is the last resort measure that shows weakness in the market as the banks are dispirited by the high-interest rates the Fed offers.
Federal Funds Rate
The federal funds rate is the target interest rate put in place by the Federal Open Market Committee (FOMC). This target is the rate that commercial banks use for their excess reserves to be lent and borrowed overnight. The Federal Open Market Committee meets eight times yearly to lay the target rate, which also helps with economic growth. The banks need to sustain the reserve requirement that is based on the total deposit percentage. Rate adjustments are made by the economic signs such as recession, inflation, etc. The federal funds rate is important, directly impacting growth, inflation, employment, and the US economy. It also affects short-term interest rates and credit card loans. The rate the banks charge the creditworthy borrowers, called the prime rate, is also affected by the federal funds rate,
Nominal Interest Rate
Nominal interest rates indicate the actual cost lenders pay borrowers to use their money. These are interest rates instituted for bonds or loans. If a nominal interest rate is, for example, 10%, every 100 dollars will constitute 10 dollars in interest paid. Inflation does not affect nominal interest rates—the stated rate without the impact of inflation/deflation.
The nominal interest rate is usually indicated yearly. Some uses of the nominal interest rate in the real world include: personal loans, mortgages, and credit cards. It is also used by financial organizations to display their loan products.
Real Interest Rate
In contrast to nominal interest rates, the real interest rate is adjusted for inflation. The real interest rate is calculated as the current nominal interest rate minus the anticipated inflation rate. This interest rate is proper when making financial decisions, particularly with loans and investments. It is essential to consider the real interest rate when analyzing the cost of borrowing or investment yields. Real interest rates are beneficial when it comes to the growth of investments in the long term because high real interest rates will secure growth in your investments.
Knowing about the different types of inflation rates can still be helpful to the individual who is looking to make a significant investment. Knowledge about interest rates can help you pay the lowest levels of interest on your loans and make the highest margins on any bonds you buy (Real interest rates determine return rates). Lastly, even if the interest rate does not directly impact you, monitoring these rates can tell you volumes about the state of the economy, what monetary policies are being enacted, and much more.
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