Nominal interest rates reflect borrowing costs or investment returns before inflation

You're likely to see nominal interest rates quoted when shopping for credit or a savings account. Ariel Skelley/Getty

• The nominal interest rate is the rate of interest before adjusting for inflation.
• As a consumer, you're most likely to see nominal interest rates quoted when shopping for credit or a savings account.
• The nominal interest rate is a basis for calculating the other types of interest rates.

Interest, by its simplest definition, is the fee attached to money, whether borrowed, loaned, or invested. However, there are several different types of interest rates, and your projected costs or returns can look very different depending on which of them you're looking at.

The nominal interest rate is one you'll commonly see quoted at your local bank or credit union.

What is a nominal interest rate?

The nominal interest rate is the rate of interest before adjusting for inflation. It's the rate financial institutions often advertise for things like bank loans, mortgages and savings accounts.

While the nominal interest rate does reflect the borrowing costs on loans and returns on savings, it doesn't provide a full picture. Without accounting for inflation, the actual costs or returns can vary widely as the purchasing power of money changes over time.

Where nominal interest rates are used 

As a consumer, you're most likely to find nominal interest rates quoted when shopping for credit or looking to put money into an interest-bearing account. You'll also probably see other types of interest rates including annual percentage yield (APY) and annual percentage return (APR), which take into account other factors including the effect of compounding and non-interest costs associated with a loan.

"A nominal interest rate is the face value of the interest you pay on a loan," says Nicholas Creel, assistant professor of business law at Georgia College and State University. 

The nominal interest rate is a basis for calculating other types of interest rates.

Nominal vs. real interest rate

In contrast to the nominal interest rate, the real interest rate does consider inflation. 

"A real interest rate will adjust to remove the effects of inflation and give the real rate of a bond or loan," says Steve Azoury of Azoury Financial in Michigan. So, the real interest rate equals the nominal interest rate minus the actual inflation rate. 

Investors can use real interest rates to understand their purchasing power. For example, let's say that you put funds in a savings account with a nominal interest rate of 3%. If actual inflation is 2%, then the real interest rate is 1%. With that, your purchasing power increases by 1%. 

"Real interest rates are rates that already have inflation factored into their equation," Azoury says. "This rate gives the real rate of a loan or bond and will show how far a dollar will go for investors."

It's possible to have a negative real interest rate if the actual inflation rate is higher than the nominal interest rate. 

How are nominal interest rates set?

When the Federal Reserve sets the federal funds rate, that acts as the short-term nominal interest rate. It serves as a baseline for the interest rates charged by lenders and earned by savers.

Banks and other lenders consider projected inflation rates when setting their nominal interest rates. They set rates that allow them to earn money from their products and services and adjust them regularly. Here's the basic formula:

Nominal interest rate = real interest rate + expected inflation

Banks in the US react to the short-term rates set by the Fed and adjust their nominal interest rates accordingly when they're changed. However, real interest rates will vary from one bank to the next.

While the federal funds rate plays a role in all of them, each individual bank's nominal interest rates will also take into account its own operating costs and other factors to determine a rate that is both competitive and profitable. Be sure to shop around for the best deal.

The nominal interest rate allows you to compare opportunities across loan products and savings accounts. However, you'll need to determine the real interest rate to understand how the loan product or savings account will impact your purchasing power.