Real interest rates vs Interest rates

The title must be enigmatic for some and familiar to others. For the sake of those who would be wondering what is it all about, read ahead.

Interest rates are defined as just interest rates – the rate of interest which you earn on your investments, plain and simple.

The real interest rates are defined as the interest rates adjusted for inflation. In your investment portfolio, it is the real interest rates that should assume importance and not the simple interest rates. Why? Let’s see.

Suppose you invested $100 in one of the investment schemes for a period of 12 months. The return on your investment is 10%. It would mean that at the end of the investment tenure you have a investment return value of $110.

Say, the inflation rate for the same corrosponding period was 5%.

Effectively it would mean that while you got a return on your investment of 10%, the purchasing power of your $100 went down by 5%  i.e. the x item that you could have purchased in $100 is now costing $105.

So you have generated a wealth of $5 only at the end of the 12 month period. (against the $10 value that you might actually be thinking)

This is why, the real interest rate is a better guiding tool for the calculating the return on your investments.