Effective Annual Rate
Basically the effective annual rate (EAR) is the annual rate of interest that accounts for the effect of compounding. If you don't know what compounding is, please refer to our explanation here.
To see how much more you can earn using this method, let’s use an example:
We can use this formula to calculate EAR :
If we look back at our explanation about compound Interest, we can see there is a difference of earning between simple interest and compound interest. Although both method are using same interest rate which is 5% interest /month. And using the formula above, you can compare the normal interest rate and the EAR.
Example: Amount of investment $ 100.000, interest rate 12% per year, compounded monthly.
Using the same formula here we can calculate how compound interest will affect your earning in a year.
Simple interest rate = $100.000 * 12% * 1 year
Simple interest rate = $12.000
So by the end of the year, you will have $100.000 + $12.000 = $112.000.
First, you have to calculate the EAR
Lets put it in the calculation, but instead of the normal interest rate, you put the EAR rate.
Compound interest rate = $100.000 * 12.6825030% * 1 year
Compound interest rate = $12.682,50
So by the end of the year, you will have $100.000 + $12.682,50 = $112.682,50
So now you know why Effective Annual Rate is important for your investment.