Interest rates – on things such as savings accounts or bonds – are normally quoted in “nominal” terms, where inflation has not been taken into account. A “real” interest rate accounts for the impact of inflation on a given rate of interest, and it’s very important to your returns.
Say you put £100 into a savings account that pays an annual interest rate of 5%. After a year, you will have £105. But if inflation is running at 3% a year, then a basket of goods that cost £100 a year ago will now cost £103. So in reality, your buying power has only increased by £2 (£105 less £103). The real interest rate takes this into account – so your real interest rate on the £100 deposited is 2% (£2/£100), not 5%.
The simplest way to work out the real interest rate is to take the nominal rate and subtract the rate of inflation – in this case 5% less 3%. The yields on index-linked bonds do take the rate of inflation into account and tend to be quoted in real terms in newspapers or on financial websites.
Real interest rates have fallen significantly since the financial crisis, due to rates falling more rapidly than inflation. In some cases they are even negative. This means owners of bonds and many of those with savings have been losing money in real terms.