What is the Effective Annual Rate (EAR)?
Effective annual rate (EAR) is the rate actually earned on investment or paid on the loan after compounding over a given period of time and is used to compare financial products with different compounding periods i.e. weekly, monthly, annually, etc. As the compounding periods are increased, the EAR increases.
The EAR is calculated as follows:
Effective Annual Rate = (1 + i/n)n – 1
- Where n = number of compounding periods
- i = nominal rate or the given annual rate of interest
The EAR is equal to the nominal rate only if the compounding is done annually. As the number of compounding periods increase, the EAR increases. If it is continuous compounding formula, the EAR is as follows:
Effective Annual Rate (in case of continuous compounding) = ei – 1
Hence, calculation of Effective annual rate depends on two factors:
- The nominal rate of interest
- The number of compounding periods
The number of compounding periods is the major factor as the EAR increases with the number of periods.
How to Calculate?
Let us consider the following example:
Consider a nominal rate of 12%. Let us calculate effective annual rate when the compounding is done annually, semi-annually, quarterly, monthly, weekly, daily and continuously compounded.
- EAR = (1 + 12%/1)1 – 1 = 12%
Semi – Annual Compounding:
- EAR = (1 + 12%/2)2 – 1 = 12.36%
- EAR = (1 + 12%/4)4 – 1 = 12.55%
- EAR = (1 + 12%/12)12 – 1 = 12.68%
- EAR = (1 + 12%/52)52 – 1 = 12.73%
- EAR = (1 + 12%/365)365 – 1 = 12.747%
- EAR = e12% – 1 = 12.749%
Thus, as can be seen from the above example, the calculation of effective annual rate is highest when it continuously compounded and the lowest when the compounding is done annually.
The calculation is important while comparing two different investments. Let us consider the following case.
An investor has $ 10,000 which he can invest in a financial instrument A which has an annual rate of 10% compounded semi-annually or he could invest in a financial instrument B which has an annual rate of 8% compounded monthly. We need to find which financial instrument is better for the investor and why?
To find which instrument is better, we should find the amount he will get after one year from each of the investments:
Amount after one year in Investment A = P * (1 + i/n)n
Where P is the principal, I is the nominal rate and n is the number of periods of compounding which is 2 in this case
- Hence, amount after one year in investment A = 10000 * (1 + 10%/2)2 A = $ 11025
Amount after one year in Investment B = P * (1 + i/n)n
Where P is the principal, I is the nominal rate and n is the number of periods of compounding which is 12 in this case
- Hence, amount after one year in investment A = 10000 * (1 + 8%/12)12= B = $ 10830
Thus, in this case, investment A is a better option for the investor since the amount earned after one year is more in investment A.
If the interest is compounded, it results in higher interest in the subsequent periods, the highest being in the last period. Till now, we have considered total amounts at the end of the year.
Let us see the following example to find interest at the end of each period.
A financial instrument had an initial investment of $ 5000 with an annual rate of 15% compounded quarterly. Let us calculate the quarterly interest received on the investment.
The rate is compounded quarterly, hence the interest rate for each quarter = 15%/4 = 3.75%
Interest earned in first quarter = P(1+i/n)n – P = 5000*(1+15%/4) – 5000 = $ 187.5
- Now, the new principal is 5000 + 187.5 = $ 5187.5
Thus, Interest earned in second quarter = P(1+i/n)n – P = 5187.5*(1+15%/4) – 5187.5= $ 194.53
- Now, the new principal is 5187.5+ 194.53 = $ 5382.03
Thus, Interest earned in third quarter = P(1+i/n)n – P = 5382.03*(1+15%/4) – 5382.03= $ 201.82
- Now, the new principal is 5382.03+ 201.82 = $ 5583.85
Thus, Interest earned in fourth quarter = P(1+i/n)n – P = 5583.85*(1+15%/4) – 5583.85= $ 209.39
- Hence, the final amount after one year will be 5583.85 + 209.39 = $ 5793.25
From the above example, we have seen that the interest earned in the fourth quarter is the highest.
The effective annual rate is the actual rate which the investor earns on his investment or the borrower pays to the lender. It depends on the number of compounding periods and the nominal rate of interest. The EAR increases if the number of compounding periods increases for the same nominal rate, the highest being if the compounding is done continuously.
This has been a guide to the Effective Annual Rate and its definition. Here we also discuss examples of effective annual rate along with its interpretations. You can learn more from the following articles –