This is done to make consumers believe that they are paying a lower interest rate.įor example, for a loan at a stated interest rate of 30%, compounded monthly, the effective annual interest rate would be 34.48%. When banks are charging interest, the stated interest rate is used instead of the effective annual interest rate. Why Don’t Banks Use the Effective Annual Interest Rate? To calculate the effective annual interest rate of a credit card with an annual rate of 36% and interest charged monthly: Apply the EAR Formula: EAR = (1+ i/n) n – 1 The compounding periods may be 12 (12 months in a year) and 4 for quarterly (4 quarters in a year).ģ. The compounding periods are typically monthly or quarterly. Determine the number of compounding periods Example: “Annual rate 36%, interest charged monthly.” 2. The stated interest rate (also called the annual percentage rate or nominal rate) is usually found in the headlines of the loan or deposit agreement. To calculate the effective interest rate using the EAR formula, follow these steps: 1. Δ How to Calculate the Effective Interest Rate? Download the Free TemplateĮnter your name and email in the form below and download the free template shown above now! The effective annual interest rate allows you to determine the true return on investment (ROI). Even though the bank offered a 12% stated interest rate, your money grew by 12.683% due to monthly compounding. 12683 or 12.683%, which is the effective annual interest rate. The table below demonstrates the concept of the effective annual interest rate: EAR Exampleįor example, assume the bank offers your deposit of $10,000 a 12% stated interest rate compounded monthly. In the case of compounding, the EAR is always higher than the stated annual interest rate. The effective interest rate is important in figuring out the best loan or determining which investment offers the highest rate of return. The stated annual interest rate and the effective interest rate can be significantly different, due to compounding. The effective annual interest rate is an important tool that allows the evaluation of the true return on an investment or true interest rate on a loan. Table: CFI’s Fixed Income Fundamentals Courseįor example, the EAR of a 1% Stated Interest Rate compounded quarterly is 1.0038%. The table below shows the difference in the effective annual rate when the compounding periods change. Compare it to the Annual Percentage Rate (APR) which is based on simple interest.Įffective Annual Rate Based on Compounding The effective annual interest rate is also known as the effective interest rate (EIR), annual equivalent rate (AER), or effective rate. Simply put, the effective annual interest rate is the rate of interest that an investor can earn (or pay) in a year after taking into consideration compounding.ĮAR can be used to evaluate interest payable on a loan or any debt or to assess earnings from an investment, such as a guaranteed investment certificate (GIC) or savings account. The Effective Annual Interest Rate (EAR) is the interest rate that is adjusted for compounding over a given period. Updated JanuWhat is the Effective Annual Interest Rate?
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