Effective annual rate is an annual rate of interest when compounding occurs more than once in a year. This can be used to compare the annual effective interest among the loans with different nominal interest rates and/or different compounding intervals such as daily, weekly, monthly, quarterly or half yearly. Effective annual rate (EAR), is also called the effective annual interest rate or the annual equivalent rate (AER).
Use of EAR:
Lets say we need to compare loans offered by 2 different Banks. Bank A, offers you 7.18% interest compounded weekly while Bank B, offers you at a higher rate of 7.24% but compounds interest quarterly. Without considering any other fees at this time, Lets find out which is better option.
Bank A – at 7.18% compounded 52 times per year the effective annual rate calculated is 0.0724387 i.e. 7.24%
Bank B – At 7.24% compounded 4 times per year the effective annual rate calculated is 0.074389 i.e.7.24%
So based on nominal interest rate and the compounding per year, the effective rate is essentially the same for both loans.
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