The stated interest rate on a bond or loan is the Nominal Interest Rate, which represents the real monetary amount borrowers pay lenders to utilise their money. If a loan’s nominal interest rate is 5%, borrowers may expect to pay Rs. 5 in interest for every Rs. 100 borrowed. Because it was previously imprinted on the coupons redeemed by bondholders, this is sometimes referred to as the coupon rate.
The effective interest rate, which takes compounding into account, is something that investors and borrowers should be aware of. For example, if a bond pays 6% yearly and compounds semi-annually, an investor who invests Rs. 100,000 will get Rs. 3000 in interest after the first six months (100,000 x.03), and Rs. 3090 after the next six months (103000 x.03). This investor receives Rs. 6090 in total for the year. While the nominal rate is 6%, the effective rate is 6.09 percent in this case since the interest received at the end of 6th month can also be reinvested to earn more interest.
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. The real interest rate reflects the rate of time-preference for current goods over future goods. The difference between the nominal interest rate and the inflation rate is used to determine the real interest rate of an investment:
Nominal Interest Rate – Inflation Equals Real Interest Rate (Expected or Actual)