Effective Annual Rate (EAR) is the actual interest rate an investor earns or pays in a year after accounting for compounding. It provides a true reflection of the annual cost of borrowing or the annual return on investment.
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EAR considers the effects of compounding, unlike nominal interest rates.
EAR can be calculated using the formula: EAR = (1 + i/n)^(n*k) - 1, where i is the nominal rate, n is the number of compounding periods per year, and k is the number of years.
It allows investors to compare different financial products with varying compounding periods.
Higher frequency of compounding results in a higher EAR for the same nominal rate.
Understanding EAR is crucial for evaluating investment returns and comparing loan costs effectively.
Review Questions
What does Effective Annual Rate (EAR) account for that nominal interest rates do not?
How does increasing the frequency of compounding affect the Effective Annual Rate?
Why is EAR important when comparing different financial products?
Related terms
Annual Percentage Rate (APR): The annual rate charged for borrowing or earned through an investment, without accounting for compounding within that year.