When you receive the repayment of principal plus interest at the end of a year, interest is calculated using the nominal interest rate. However, if there is inflation, your money lost some buying power, compared against the buying power of the principal amount at the time it was deposited. So, if you want to get your real interest rate, you should take inflation into account. The relationship between nominal and real interest rates under inflation is given by the Fisher equation, named after Irving Fisher.
The Fisher equation is:
- nominal interest rate
- real interest rate
- inflation rate
Hence, the real interest rate would be
Note that for small rates (several percents) Fisher equation can be approximated as