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Effective Annual Rate and Annual Percentage Rate

Effective Annual Rate and Annual Percentage Rate

The effect of compounding interest more frequently than annually have on its future value and the effective annual rate (EAR)

Compounding Frequency

Compounding frequency is the number of times the interest regularly accumulates, for example, once, twice, four times, and twelve times a year. The effect of compounding depends on the frequency and the nominal interest rates. An increase in the frequency of compounding increases the returns. Therefore, as the compounding periods increase, the effective interest rate increases. Therefore, effective interest rates are the real rate of return when the various factors to the investment are considered.

Effective Annual Rate and Annual Percentage Rate

Rate of Return

This facilitates the accurate calculation of the rate of return and thus the opportunity cost of each investment. Therefore, the effect of compounding strengthens with the increase in the number of times the returns are compounded annually. This invests in growing faster as the snowballing effect increases. Therefore, the effective interest rate would be highest in the case of continuous compounding, where the interest is compounded hourly or daily.

Difference between the annual percentage rate (APR) and effective annual rate (EAR)

Annual Percentage Rate

The annual percentage rate (APR) is the annual interest that has been generated to pay the investor and borrower. The APR of each financial instrument has to be disclosed before they are required to sign the contract. The annual percentage interest rate may not reflect the actual cost of capital. It, however, provides the investor or borrower with a rough estimate of the payment within a given period.

Effective Interest Rate

On the other hand, the effective interest rate is the actual return rate of investment. It considers the borrowers, credit history, credit score, loan size, loan term, loan type, and the frequency of payment. Therefore, unlike the EAR, APR is simple and facilitates the quick calculation of the cost of capital. Additionally, APR does not account for the compound interest, thus making it less accurate than EAR.

Effective Annual Rate and Annual Percentage Rate

References

  • Akan, M., & Tevfik, A. T. (2020). Fundamentals of finance. In Fundamentals of Finance. De Gruyter.
  • Fanozzi, F. J. (2020). Finance: Capital Markets, Financial Management and Investment Management.

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