Final answer:
The difference between nominal and real interest rates lies in whether or not inflation is taken into account. In the context of a mortgage on a home, the real interest rate determines the actual cost of borrowing and the purchasing power of the borrower's monthly mortgage payments. Understanding the real interest rate helps borrowers assess the true cost of their mortgage and make informed decisions.
Step-by-step explanation:
The difference between nominal and real interest rates is that the nominal interest rate is the rate before taking inflation into account, while the real interest rate is the rate after adjusting for inflation. The nominal interest rate represents the actual interest rate that is stated on a loan or investment, whereas the real interest rate reflects the purchasing power of the interest earned or paid. In the context of a mortgage on a home, the real interest rate is important because it determines the actual cost of borrowing and the purchasing power of the borrower's monthly mortgage payments.
For example, if a borrower secures a mortgage at a nominal interest rate of 5% and there is an inflation rate of 2%, the real interest rate would be 3%. This means that even though the borrower is paying 5% in nominal interest, the actual cost of borrowing after adjusting for inflation is only 3%. Conversely, if there is deflation of 2%, the real interest rate would be 7%, making the cost of borrowing higher than the nominal interest rate.
Understanding the real interest rate is crucial for borrowers because it allows them to assess the true cost of their mortgage and make informed decisions. If inflation is high, the real interest rate can be lower than the nominal interest rate, which can make borrowing more affordable. Conversely, in a low or negative inflation environment, the real interest rate can be higher than the nominal interest rate, making borrowing more expensive. This information helps borrowers in comparing different mortgage offers and determining the most suitable option for their financial situation.