There Are Interest Rates and Then There Are Real Interest Rates

Remember that passbook savings account you had as a kid? You would take your money to the bank and the teller would write your deposit amount and the interest you had earned into your passbook. Ah, that was the simple life.

Your teller was writing in your nominal interest rate. Now that you are all grown up, you might want to be thinking about your “real interest rate” instead of your nominal rate. This will help you figure out whether and how much your purchasing power will change during your golden years.

Real Interest Rates
Real interest rate equals nominal interest rate minus inflation rate. Most people think of the inflation rate as something that is known. It is reported in the past tense. But when you are evaluating an investment and the nominal interest rate, future inflation rate is a guess or a prediction.

So, if you lock in a 5% interest rate for the coming year and you think inflation will be 1%, you are expecting or hoping to increase your savings by 4%. Thus, 4% is your expected real interest rate. If your friend buys the same investment at 5% but thinks inflation will be 2%, then she is expecting to grow her savings by her expected real interest rate of 3%.

Inflation is the rate at which the prices of goods and services rise. When the price of goods and services rise, your purchasing power falls.

If your investment is in bonds that carry a 2% nominal interest rate and inflation is running at 3%, you have a real interest rate of a negative 1%. You would be losing ground. This is actually more or less how US Treasury bonds are behaving these days.

TIPS: Interest rates steady while investment changes
For those of you who are concerned about losing the race against inflation, you might want to read up on TIPS, Treasury Inflation-Protected Securities. They are popular with long-term investors who want to preserve their purchasing power over many years.

Like US Treasury bonds, TIPS are backed by the U.S. government. Both kinds of securities are loans to the government. With both investments, you get interest payments twice a year based on a fixed interest rate. TIPS are a little different from traditional US Treasury bonds. TIPS guarantee that your real interest rate will keep up with inflation. The key is to hold onto the TIPS until it matures.

The amount of principal invested in your TIPS is automatically adjusted every six months, based on the ups and downs of the Consumer Price Index (a measure of inflation). So, while your interest rate stays the same, the amount of interest will fluctuate based on the revised investment or principal amount

As a hypothetical TIPS example, we can take a $20,000 TIPS investment. It has a fixed interest rate of 2.5%. You would expect the first semi-annual interest payment to be $250. However, during the first six months, the Consumer Price Index (a measure of inflation) goes up at an annual rate of 3%. The $20,000 investment will go up by half that annual inflation rate or 1.5% to $20,300.

This new investment balance is going to change the semiannual interest payments. The original 2.5% interest rate stays, but the investment amount changes. Thus, the original 2.5% interest rate is multiplied times the newly adjusted investment amount of $20,300. This causes the next interest payment to be $253.75 instead of $250. Every time inflation rises, your interest payment rises because the investment balance is adjusted.

Earlier I mentioned that the key is to hold the TIPS to maturity. When you hold a TIPS to maturity, the investment you are repaid will likely be greater than the amount you originally invested, in a period of inflation. If there is a period of deflation, when the TIPS matures the investment you are repaid will be the inflation-adjusted investment amount or the original investment amount, whichever is greater.

Need to know
If the Consumer Price Index falls over six months, the investment amount will be adjusted downward. This will cause the next interest payment to be lower than previously. If the Consumer Price Index is ever negative (a sign of deflation), the investment balance and the interest payments will both drop.

TIPS are not tax-free. Federal taxes will be due every year on the interest you receive as well as the adjusted increase in your investment. You might want to consider investing tax-deferred money in a TIPS, such as in an IRA account.

You have many other investment options. Since a TIPS will generally offer a lower interest rate than other options, you must consider whether the expected inflation rate is high enough to cover the difference between the low TIPS interest rate and a non-TIPS interest rate. A financial advisor can help you decide whether a TIPS investment is right for you as you try to win the race against inflation.