Real Rate Of Return: Calculating Formula, Definition, and Nominal Difference

New to investing? Still figuring out the lingo?

Here’s a financial glossary entry that can help you maximize returns on your investments: real rate of return.

What is real rate of return — and why does it matter? In this article, you’ll learn everything you need to know, including the real return formula, the meaning of nominal return vs. real return, and more. Keep reading to learn how to use the real rate of return to help make the most of your money now and in the future…

What is Real Rate of Return?

The real rate of return definition is pretty simple: it refers to the return on a given investment after taking into account the rate of inflation.

As for related terms — what is the nominal rate of return on investment? The nominal rate of return is usually the rate advertised to you when you’re getting into a particular investment.  However, this does not take into account either inflation or taxes and can be quite misleading so it’s important to be aware of the rates of nominal return vs. real return.

For example:

• If you make an investment with an advertised 10% annual return rate (the nominal return rate)…
• But inflation in your country is 6%…
• The real rate of return would be a mere 4%.

This is important to consider and not to be overlooked because inflation and taxes erode returns substantially.  

All told, the real rate of return is a more accurate metric of your investment performance than the advertised (nominal) rate of return.

Real Rate of Return Formula

The formula to calculate real rate of return is as follows:

Real rate of return = (1 + Nominal Rate) / (1 + Inflation Rate) – 1

With this simple real return formula, you can get a better idea of your annual earnings from a particular investment.

But keep in mind — this does not take into account the tax rate you’ll also be paying on said investment.

To figure that out, use the formula below:

Tax Adjusted Nominal Rate = Nominal Rate x (1 – Tax Rate)

Using both of these formulas will help you gather accurate information about your investment and figure out the real rate of return for what you’re getting into.

Real Rate of Return vs. Nominal Rate of Return

Once you find out the nominal return vs real return, it can be disheartening to realize your investment may not have as much profit potential as you thought.

Even if a nominal rate sounds good, it’s still subject to inflation which can eat up the profits of investing based on the rate of inflation.

In short, the real rate of return will always be lower than the nominal rate of return simply because the nominal rate never took into consideration inflation and the taxes you’ll have to pay on your investment.

Figuring out the real rate of return can help you make more savvy investment decisions than relying solely on the nominal rate of return.

Difference Between a Real and Nominal Interest Rate

To make it abundantly clear — the key difference between a real interest rate and a nominal interest rate is that the former accounts for factors like inflation.

• Nominal Interest Rate: The nominal interest rate is the advertised rate of return on investment (e.g. the interest rate offered by banks on checking accounts).

• Real Interest Rate: The real interest rate is the actual rate of return on an investment after taking into account the inflation rate and any taxes you may have to pay on said investment.

Why is Real Rate of Return Important?

It’s important to be cognizant of the real rate of return because it shows you the actual projected return that you’re likely to see on an investment.

Without the flashy promises made via nominal or advertised rates, it’s a clear picture of what and how much you’ll actually see as an annual return.

This can save you from potentially dismal returns and let you know just exactly what investments are worth their salt.

How to Use Real Rate of Return: Example

How do you actually use the real rate of return? I’ll walk you through an example.

Say you’ve got a good chunk of money sitting around and people keep telling you to ‘put your money to work’ so you figure you’ll put it into a bank account where it can earn interest.

You’ve looked around at several banks for the best interest rate. Finally, you found one that looks good.

But is that advertised interest rate what you’ll actually make?

Here’s where the real rate of return formula comes in.

Typically, what’s advertised is the nominal rate of return. But this doesn’t take into account things like inflation and taxes.

Once those things are taken out of the advertised interest rate, the real rate could, in fact, be much less impressive.

For example, say that you found a bank that offers 5% interest.

You put $10,000 in initially and in 12 months you have $10,500.

Unfortunately, inflation increased prices by 3% over the last year, so your initial $10,000 worth of buying power is now only $9,700 worth of buying power.

This means that while your investment did appreciate, it only made $200 instead of what you thought was going to be $500.

By using the real rate of return formula, you can better anticipate events like this.

It can simply be a reality check, or it can save you from putting your money into something that won’t be worthwhile.

Not only is it a time saver, but using the real rate of return formula can help you get the most out of your money.

Factors That Affect Real Rate of Return

What are the factors that affect the real rate of return?

We’ve already discussed the big ones: the nominal rate, the inflation rate, and taxes paid.

Additionally, If deflation or negative inflation (when inflation rates are higher than interest rates) occurs, the real rate of return could be significantly impacted and even go into negative interest rates. (This plays a role in why the FED has continuously raised interest rates recently).

That said, there still exists a problem that can affect your investment.

The Problem With Real Rate of Return

The problem with the real rate of return? Inflation, which is a crucial part of the calculation, is a trailing indicator that can only be calculated after the fact.

As such, the real rate of return is an imperfect science. Nobody is sure just what exactly the inflation rate will be over the period you’ve invested your money.

Sure, we have a model for predicting inflation called the Consumer Price Index — but it can only merely predict based on existing information.

This means that we can only go on predictions based on past performance but if something extreme happens, it could really change the playing field.

Final Word: Real Rate of Return

The real rate of return, i.e. the nominal rate accounting for inflation and taxes, can help you determine whether your investments will perform well or if they’ll be, for lack of a better word, stagnant.

It can also show you the difference between what you thought you’d make and what you’ll actually be making. That part might be a downer, but it keeps your expectations realistic.

Ultimately, the real rate of return can guide you to make smarter investments and manage your money more intelligently.

The bottom line? It’s worth taking the time to calculate the real rate of return on your investments. While unknown factors like the exact rate of inflation can hamper the real rate, it’s a valuable tool in figuring out just how your investments are going to perform over time.  

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