- Effective annual interest (EAIR) takes capitalization into account.
- The effective annual interest rate reflects the actual cost of borrowing or the rate of return on deposits.
- Understanding how effective annual interest rates work allows you to compare financial instruments and find the best deal.
Interest is essentially the money you make on a loan or make a deposit or investment. However, not all interest rates are calculated in the same way. There are several types, and loan costs and repayments may vary depending on which one you use.
One of the most discussed is the effective annual interest rate (EAR). This is the rate you pay or earn after considering the effects of compound interest.
Effective annual interest rate system
The effective annual interest rate reflects the actual cost of the loan or the return on the deposit after calculating the impact of compound interest.
Compound interest occurs when previously earned interest is added to the principal of an investment or loan. This can work to your advantage as interest-bearing accounts and investments increase over time, but it can be detrimental when paying off debt such as credit cards.
“Interest is synthesized on a regular basis (daily, monthly, quarterly, etc.) and the amount is immediately added to the balance, so the balance continues to grow over the next period. That is, the interest paid on the balance. Will also increase. ” Shazia Virji, Managing Director of Credit Services at Credit Sesame.
“Think of it as paying interest on your own. The more complex your interest is, the higher your interest rate will be.”
Compound interest can be for you or against you. If you are borrowing money, compound interest will result in increased debt for the lender. If you are investing money, compound interest will help your money grow faster. The effective annual interest rate helps determine what you actually pay or earn.
$10,685
Your balance after 5 years
$5,000
$2,500
How to calculate the effective annual interest rate
You can run the numbers to determine the effective annual interest rate.
The formula is:
Effective annual interest = (1 + i / n) ^ n -1
- I = he Nominal interest rate (Interest rate before inflation adjustment)
- n = number of compound interest calculation periods
Example of effective annual interest rate
Calculating the effective annual interest rate will help you find the best deal. Let’s look at an example.
Suppose you want to buy an investment product. Bank 1 offers 5.25% interest and is compounded daily. Bank 2 offers compound interest of 5.35% every six months. In these offers, the interest rates announced are the nominal interest rates.
Here’s how the numbers fluctuate:
- Bank 1: (1 + 5.25/365) ^ 365-1 = 5.3899%
- Bank 2: (1 + 5.35 / 2) ^ 2-1 = 5.3702%
In this case, Bank 1 has the best offer. Nominal interest rates are low, but more frequent compound interest rates result in higher effective annual interest rates.
Annual effective interest rate vs. APY
Annual Interest (APY) is the rate of return you earn from your savings account over the course of a year. Some examples include certificates of deposit (CD), money market accounts, and savings accounts. The announced APY takes into account the capitalization effect.
The difference between this and the EAR is usually in the context in which they are described.
“APY is commonly used for savings and investments that make consumers compound interest,” says Virji. “EARs are commonly used to refer to the amount a consumer has to pay. Both interest rates incorporate the compound interest effect of interest rates, as opposed to the interest rates listed.”
Put everything together
The next time you look for a loan or investment product, make sure you always understand what the advertised interest rates are and what they represent. The effective interest rate provides a complete picture of the costs you incur or the income you receive.
“Taking into account the complex nature of fees, interest, and debt and investment, it becomes clear what the actual cost of buying with credit and what you can expect from your investment,” said Charles Bulthuis, President of Reformation. Says. asset management. “It allows you to make a fully informed decision as to whether a loan or investment is a wise use of your hard-earned money.”