The effective annual rate or EAR calculator is an incredible tool designed specifically for those interested in investments and loans. Whether they want to make an investment or take out a loan, this calculator can help them determine effective annual rates. If you’re one of those people, this tool is right for you.
But before starting to use it, you should first find out more about the effective annual rate. Then you need to learn how to calculate EAR yourself. In this article, you can find the EAR formula and other interesting facts about the effective annual rate. So keep reading to learn more.
What Is EAR?
EAR or effective annual rate is a financial term that is used to express the interest rate of a loan, mortgage, or credit card. Likewise, the annual percentage rate is the total cost of borrowing and includes the interest, fees, and other charges.
The effective annual rate is the cost of borrowing in terms of a yearly percentage. It takes into account all of the costs associated with borrowing such as interest, fees, and other charges. In essence, the effective annual rate is calculated by taking the nominal annual interest rate and multiplying it by the number of compounding periods in one year. The EAR formula is a bit different, though. We will check it out later on.
More Facts about the Effective Annual Rate
Basically, the EAR is a type of interest rate. There are many different types of interest rates. We’ve mentioned APR, which is also a type of interest rate. We could, of course, simplify things and use our nominal interest rate to estimate the cost of a loan or a credit card.
One of the main problems is that the basic nominal rate doesn’t include the effects of compounding and also doesn’t include any additional costs. If we take into account the compounding interest, we get the EAR. If we take into account additional costs, we get the APR.
Therefore, EAR essentially is an interest rate that is a more precise measurement of the cost of a loan. For example, let’s consider a loan with a nominal rate of 6% versus a simple credit card with the same interest rate.
Based on the nominal interest rate, you might think those two options are the same in terms of cost. But if we are to use EAR for the comparison, we get that the first option has a 6% EAR, but the second option has an EAR of 6.17%. This lets us know that the credit card is a more pricey option.
EAR Calculation: How Does It Work?
In general, it is always a good idea to consider your EAR while making a decision about credit cards and loans. If you are investing money, be sure to calculate APY first. Don’t let the terminology confuse you, it is basically the same thing.
If you are thinking about some kind of debt EAR will probably come up somewhere. On the other hand, if you’re thinking of investing, APY is the term you’ll likely find. In any case, it is smart to use EAR/APY when comparing all your options.
Even though the math behind EAR is not particularly complicated we could always use the calculator to help us find the result. Let us now consider a different nominal rate. Let’s say we have a nominal interest rate at 5%, and we’ll keep the number of periods the same. If we enter these parameters in our calculator we’ll get the result of 5.12%.
We can clearly see that EAR is larger than the nominal interest rate, 5.12 > 5. This happens because of the compounding effect. If we were to pick 1 instead of 12 as our number of periods, what would happen? The result would be 5, exactly the same as the nominal interest rate. Why?
When we have only one payment period per year, there is no compounding. When there’s no compound interest EAR is the same as the nominal interest rate. But as soon as we introduce the number of periods larger than 1, we get the effect of compounding. If n is equal to 2, the EAR is then equal to 5.06%. The nominal interest rate in all of these examples is constant at 5%.
EAR Formula: How to Calculate the Effective Annual Interest Rate
In finance, the EAR is typically calculated using the following formula:
EAR = (1 + Annual Interest Rate / 12) ^12− 1
You can also use this formula:
EAR = (1 + r / m) ^ m − 1
Where:
- r – It is the stated or quoted rate (also called the nominal interest rate). This is actually the annual interest rate expressed in percentage.
- m – This metric represents compounding periods and it shows how many times compounding happens in a year. Since it occurs every month in most cases, we will assume that “m” is 12.
Let’s take an example to help you understand how it works in real life. We will say that the annual interest rate is 4.00%. In our example, the EAR is as follows:
EAR = (1 + Annual Interest Rate / 12) ^12− 1
EAR = (1 + 0.04 / 12) ^12− 1
EAR = 4.07%
What’s the Difference between EAR and APY?
Annual Percentage Yield (APY) is the annualized interest rate. This term is used in the banking industry to describe the interest rate on a savings account. It is also known as the nominal rate of interest. The APY is expressed as a percentage and it tells how much you will earn on your investment over a year.
Hence, it is computed by taking the interest rate and multiplying it by the number of periods in a year. APY can be calculated by taking the nominal interest rate and multiplying it by the number of periods in a year.
APY is often used to compare different investments because it takes into account both the size of your deposit and its return. EAR takes into account all costs associated with borrowing money, such as fees and compounding. This makes a difference between them.