Effective Annual Rate
The effective annual rate represents the actual rate of interest earned or paid on a financial product. It takes the effect of compounding in accounts for the calculation of the actual interest rate. Effective Annual Rate Calculator is an online tool. It helps in representing the difference in the stated or nominal rate of interest and actual interest rate after compounding. This eventually helps in comparing the available options. This makes a lot of difference in the actual return and the consequent rate of return for long-maturity investments.
The nominal or stated interest rate is always lesser than the EAR. It is also known as the annual equivalent rate or effective interest rate. Before making any type of investment, the investor should always take into account the effective annual rate. And in the normal course, the investor believes that they pay a single interest rate without considering the impact of compounding. Nowadays, compounding is called the ninth wonder of the world.
Formula
For calculating the effective annual rate, consider the following formula:
Effective Annual Rate = (1 + i/n)n – 1
Where i = Rate of Interest
n = Number of Compounding Interest
About the Effective Annual Rate Calculator / Features
Effective annual rate calculator is an easily accessible online tool. The user has to just enter the following figures into it to get the desired output:
- Rate of Interest
- Number of Compounding Periods
Calculator
How to Calculate using Calculator
The person calculating the effective annual rate through EAR Calculator has to provide the following details for instant calculation.
Rate of Interest
It is the interest rate by which the financial product is compounded. And this is usually the (nominal) interest rate mentioned on the security and offer document.
Also Read: Effective Annual Rate (EAR)
Number of Compounding Periods
It defines the number of periods for which compounding of interest takes place. Further, the effective annual rate increases with an increase in periods of compounding. This means compounding monthly will provide a higher effective annual rate in comparison with one that is compounded annually.
Example of Effective Annual Rate
An example would help in providing more clarity about the concept:
Mr. X, for purchasing a new machine worth $50,000 for his factory, analyzes loans and interest rates of different banks. And he came to know that Bank T is providing loans at an interest rate of 11.3% compounded monthly. But the, Bank Z is providing loans at an interest rate of 11.5% compounded every six months.
Mr. X wants to know which bank is providing a better offer as there is a very minor difference in the interest rates.
| Banks | Interest Rates | Compounding Periods |
| Bank T | 11.3% | 12 |
| Bank Z | 11.5% | 2 |
Effective Annual Rates:
Bank T = (1 + 11.3%/12)12 – 1 = 11.9%
Bank Z = (1 + 11.5%/2)2 – 1 = 11.83%
Interpretation
Even though there is a difference of 0.2% in the nominal rates of interest of both the banks, the effective annual rate of interest changes due to different compounding periods. Further, as already stated, the more the compounding periods, the higher the EAR. Therefore, Bank Z has a higher nominal interest rate has a lower EAR. And hence, it is a better option. In other words, this gives us a simple lesson compounding periods make the difference, and the obvious lower interest ultimately works out costlier.
Cautions
Financial institutions and lenders indulged in practices of lending money by indicating lower nominal interest rates. And they do not clarify or give the effective rate of interest to attract the borrowers and thus to get more business. However, while attracting customers to make deposits, they advertise an effective annual rate as it is always higher than the nominal rate of interest.
