What Is Effective Annual Interest Rate?

A more complete understanding of how APR works and how to calculate it can provide an accurate way to compare different credit cards, loans, and investments that have different annual interest rates and compounding periods.

What is an effective annual interest rate?

EAR is the interest rate charged for compound interest (interest charged on interest) over a specified period. For example, the balance due on a credit card may include interest. If you do not pay the balance before the due date, the issuer will charge interest on the existing interest.

Alternative names: effective interest rate, annual equivalent rate, effective APR
Acronyms: EAR, EIR, AER

How to calculate the effective annual interest rate

The equation for calculating the EAR has two main components:

i: the declared interest rate (APR)
n: the number of compound periods
Here's what the equation looks like before entering your APR and compound periods:

Ear = (1 + i / n) n - 1

EAR credit card

Looking at the EAR from the perspective of your credit card balance can help you see the difference between your APR and EAR. For a $ 1,000 balance on a credit card that charges 20% APR, the interest would cost $ 200 in one year. However, most credit cards charge compound interest on a daily basis, so calculate the APR for the same $ 1,000 balance, like this:

[1 + (20% / 365) 365] - 1 = 0.2213 or, expressed as EAR, 22.13%

In this example, a credit card that advertises an APR of 20% has an APR of 22.13% and, therefore, its annual interest payment would be $ 221 instead of $ 200.

The APR will always be higher than the APR, unless there is only one annual compounding period, in which case they will be the same.

Inversion ear

When APR refers to interest paid to an investor, it operates in a similar way. If Investment A has an annual interest rate of 5%, compounded monthly, and Investment B has the same APR but compounded twice a year, then Investment Option A will have a higher overall yield or return because it is compounded with more often.

Here's how to calculate the difference between the two options if you start with a $ 1,000 investment:

Investment option A: [1 + (5% / 12) 12] - 1 = 5.11%

Investment option B: [1 + (5% / 2) 2] - 1 = 5.06%

In this example, Investment A's beginning balance of $ 1,000 will be worth $ 1,051 after one year, and Investment B will be worth $ 1,050.60. While this may not seem like a big difference, it can be significant if your original investment is larger and you invest the money for a decade or more.

Effective annual interest rate vs. APR

The APR represents the impact of compound interest, while the most commonly used annual percentage rate (APR), also known as “nominal interest,” is an annualized rate that does not take compound interest into account.

The APR is a generally accepted rate to be used by banks, credit card companies and other companies, but it is important to calculate the APR to have a more precise idea of ​​how interest will affect the result of maintaining a balance or maintaining an investment. like a CD or money market account.

We hope you enjoy watching this video about how to calculate the effective annual rate

Source: Edspira


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