Even though they both have a stated interest rate of 10%, the effective annual interest rate of the loan that compounds twice per year will be higher. Effective annual rate (EAR) is an interest rate that reflects the true return on an investment or the true amount of interest due on a credit card or loan. When banks are paying interest on your deposit account, the EAR is advertised to look more attractive than the stated interest rate. The table below shows the difference in the effective annual rate when the compounding periods change. EAR 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.
- EAR quotes are often not suitable for short-term investments as there are fewer compounding periods.
- If the investor does not agree that the market interest rate matches the stated interest rate to be paid by the borrower, the investor can bid less or more than the face amount to acquire the debt.
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Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific time period. Nominal interest rates refer to the interest rates that are unadjusted for inflation. In other words, it is the stated or quoted interest rate on a loan or investment without taking into account the impact of inflation or deflation over time. For example, for a deposit at a stated rate of 10% compounded monthly, the effective annual interest rate would be 10.47%. Banks will advertise the effective annual interest rate of 10.47% rather than the stated interest rate of 10%.
Is It Better to Have a Higher EAR?
In the case of compounding, the EAR is always higher than the stated annual interest rate. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. There are other circumstances that can alter the interest rate paid to an even greater extent.
Investors, savers, or borrowers can take nominal rates with different compounding periods (i.e. one that compounds weekly, one that compounds monthly) to see which will be most beneficial to them. The higher the effective annual interest rate is, the better it is for savers/investors, but worse for borrowers. When comparing interest rates on a deposit or a loan, consumers should pay attention to the effective annual interest rate and not the headline-grabbing nominal interest rate.
For example, if a bank offers a nominal interest rate of 5% per year on a savings account, and compounds interest monthly, the effective annual interest rate will be higher than 5%. Therefore, the bank should consider promoting the account at the EAR because that rate will appear higher. The purpose of the effective annual interest rate is to make interest rates comparable regardless of their compounding periods.
Negative Interest Rates
Banks and other financial institutions typically advertise their money market rates using the nominal interest rate, which does not take fees or compounding into account. The effective annual interest rate does take compounding into account and results in a higher rate than the nominal. The more the periods of compounding involved, the higher the ultimate effective interest rate will be. The primary difference between the effective annual interest rate and a nominal interest rate is the compounding periods.
The nominal interest rate is the stated interest rate that does not take into account the effects of compounding interest (or inflation). For this reason, it’s sometimes also called the “quoted” or “advertised” interest rate. An effective annual interest rate is the real return on a savings account or any interest-paying investment when the effects of compounding over time are taken into account. It also reflects the real percentage rate owed in interest on a loan, a credit card, or any other debt.
Understanding the Effective Annual Interest Rate
Investors and borrowers should also be aware of the effective interest rate, which takes the concept of compounding into account. The effective interest rate is the usage rate that a borrower actually pays on a loan. It can also be considered the market rate of interest or the yield to maturity.
Limitations on Effective Annual Interest Rates
Most EAR calculations also do not consider the impact of fees such as transaction fees, service fees, or account maintenance fees. On the other hand, the EAR takes into account the effects of compounding interest. It represents the true annual interest rate after accounting for the effect of compounding interest, and it is typically higher than the nominal interest rate. The term “interest rate” is one of the most commonly used phrases in the fixed-income investment lexicon.
Effective Annual Interest Rate Calculator
This rate may vary from the rate stated on the loan document, based on an analysis of several factors; a higher effective rate might lead a borrower to go to a different lender. These factors are the number of times the debt is compounded during the year, the actual amount of interest paid, and the amount the investor paid for the debt. In this context, the EAR may be used as opposed to the nominal rate when communicate rates in an attempt to lure business of transactions.
Effective Annual Rate Based on Compounding
Real interest rates are crucial for making informed financial decisions, especially in the context of investments and loans. The real interest rate is so named, because unlike the nominal rate, it factors inflation into the equation, to give investors a more accurate measure of their buying power, after they redeem their positions. If an annually compounding bond lists a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is actually only 2%. The stated annual interest rate and the effective interest rate can be significantly different, due to compounding.
