Effective annual rate (EAR)

Definition

Effective Annual Rate (EAR) is the actual interest rate an investor earns or pays in a year after accounting for compounding. It provides a true reflection of the annual cost of borrowing or the annual return on investment.

5 Must Know Facts For Your Next Test

1. EAR considers the effects of compounding, unlike nominal interest rates.
2. EAR can be calculated using the formula: EAR = (1 + i/n)^(n*k) - 1, where i is the nominal rate, n is the number of compounding periods per year, and k is the number of years.
3. It allows investors to compare different financial products with varying compounding periods.
4. Higher frequency of compounding results in a higher EAR for the same nominal rate.
5. Understanding EAR is crucial for evaluating investment returns and comparing loan costs effectively.

Review Questions

• What does Effective Annual Rate (EAR) account for that nominal interest rates do not?
• How does increasing the frequency of compounding affect the Effective Annual Rate?
• Why is EAR important when comparing different financial products?

Related terms

Annual Percentage Rate (APR): The annual rate charged for borrowing or earned through an investment, without accounting for compounding within that year.

Nominal Interest Rate: The stated interest rate on a loan or investment before taking inflation or compounding into account.

Compounding Periods: Intervals at which interest is applied to the principal balance of an investment or loan.