Definition of Effective Annual Rate
The effective annual rate or EAR is the rate that a compound interest rate offers in annual terms. Effective annual rate is used for comparing investments offering different compounding factors. For example, a bank offers three different investments; monthly, quarterly, and semi-annually at 10% per annum.
The effective annual rate will be calculated as follows:
In the above example, the monthly investment plan computes interest on principal at a monthly compounding rate i.e. (10% / 12 =0. 833%) and then reinvested at the same rate for each month. The quarterly investment plan computes interest on principal at a quarterly compounding rate i.e. (10% / 4 = 2.5%) and then reinvested at the same rate for each quarter and for semiannual the half-yearly rate is used i.e. (10% / 2 = 5%). Effectively the monthly, quarterly, and semi-annual investments plans are offering 10.47%, 10.38%, and 10.25% respectively.
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