Effective Annual Rate (EAR)
The Effective Annual Rate (EAR) is the actual interest rate earned or paid on an investment or loan after accounting for compounding over a year. Unlike the nominal rate, which doesn’t consider compounding, EAR provides a more accurate reflection of the true cost of borrowing or the real return on investment. EAR is especially useful when comparing financial products with different compounding periods, such as monthly, quarterly, or annually. EAR is a critical metric in personal and business finance, helping borrowers and investors make more informed decisions.
Example
If a bank advertises a nominal annual interest rate of 10% with monthly compounding, the EAR would be approximately 10.47%, reflecting the true cost of borrowing.
Key points
• Reflects the true interest rate after accounting for compounding.
• Provides a more accurate measure of borrowing costs or investment returns.
• Useful for comparing financial products with different compounding periods.
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