What is an Effective Annual Rate?

Definition: Effective annual rate is the actual return on a deposit per year after compounding.

What Does Effective Annual Rate Mean?

What is the definition of effective annual rate? The effective annual rate is the actual return on a deposit after taking into account the number of times interest is paid over a period of a year. It is a benchmark to compare deposits taking into account the accumulative power of earning interest on interest.

Banks will always offer an interest rate over a specific period making use of a quoted rate. This is the nominal interest rate. The effective rate of return is seldom used in advertising headlines. To do a comparison of returns on these deposits a benchmark period of one year is used. The same concept applies to loans.

The effective annual rate formula is calculated as follows:

r = ( 1 + I / n ) ^ n – 1

Where r is the effective yield, i is the nominal yield percentage and n is the number of times interest is paid over a year.

Let’s look at an example.

Example

Let’s assume Todd sees these three different ads for bank accounts offering the following interest rates.

1. Nominal interest rate of 10% per year
2. An interest rate of 9% paid twice a year
3. A nominal rate of 8.5% paid quarterly

He wants to know which bank is advertising the best deal, so all three scenarios must be converted to an effective yield. The highest effective yield is the best return for the deposit.

1. Where the nominal rate is 10% paid at the end of the year the effective rate is 10%.
2. Where the nominal rate is 9% but interest calculated semi-annually the effective rate is 9.2%
3. Where the nominal rate is 8.5% but interest earned quarterly the effective rate is 8.77%.

Thus, Todd should go with the 10% account. The above should alert business to carefully scrutinize investment decisions where interest calculations play a factor. The quoted rate is not as important as the actual rate the customer will realize.

Summary Definition

Define Effective Annual Rate: EAR is the actual interest percentage that an account or loan will pay on an annual basis.

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