Types of Interest: Fixed, Variable, Nominal, Real
Rated: 
In yet another article describing the types of interest in relation to present and future states, we have two sets of opposing terms: fixed vs. variable and nominal vs. real. How do these types of interest differ? Read on to find out more.
Fixed vs. Variable Interest
Fixed interest means interest rates that do not change throughout the period an investment or a debt grows. They are commonly found in loans for vehicles and homes, including mortgages.
The advantage of having a fixed interest rate for your debt is that you know how much you'll be paying in the future, even if other interest rates are expected to rise, in which case you have to pay more. They are commonly used in promos or limited-time offers; this means you can get relatively lower rates than other competing rates that aren't on promotion.
Of course, there are also disadvantages to choosing fixed interest rates. Any change into a more favorable interest rate won't be working for you and you'll be paying with the same rate still—this can get pretty bad when rates dip for long periods of time, as in mortgages and car loans. Also, when you've signed up for a fixed rate during a promotional offer, you will be getting that "better" rate for a limited time. If you can't clear the debt during that period, there will be a noticeable increase in the payments you have to make when a new policy is applied (e.g. a higher interest rate or variable rate).
Variable interest is essentially the opposite of fixed interest. Interest rates are subject to change and are calculated based on a reference rate such as LIBOR (London Interbank Offered Rate).
The good thing about variable interest is being able to take advantage when interest rates drop: you can pay and eventually erase that loan faster. Of course, the converse and consequent disadvantage is that with variable interest, you'll be at the mercy of rate changes, especially when they skyrocket. Consider choosing variable rates for smaller and shorter loans.
Nominal vs. Real Interest
The terms nominal and real do not only apply to interest rates but other variables in economics. In this case, the term nominal interest does not take into consideration the effects of inflation; it is the rate at which money is compounded. Real interest is the opposite: inflation has already been factored in. It is equal to nominal interest minus the inflation. Real interest rates are normally lower than nominal interest rates since inflation rates are often positive values.
The relationship between nominal and real interest is given by the following equation:
N = R + I
or
R = N - I
In the formula, N is the nominal interest rate, R is the real interest rate, and I is the inflation rate.
From a lender's or investor's perspective, real interest is the actual value of the earnings he/she gets back. If real interest rates are negative—meaning inflation rates are greater than nominal interest rates—then you are more likely to lose when you invest or lend since the purchasing power or the real value of money is lower.
On the other hand, if you are borrowing, negative real interest rates are more advantageous since the real value of the money you use to pay back your debt is lower than the value of the money when you borrowed it.
Print Article
Send to a friend
Save as PDF