For companies extending credit, it is crucial to understand how interest rates are calculated. But not just that - even if you are using credit for your business financing, it is critical to understand these matters. This is why we've compiled this short guide to calculating an effective annual interest rate (EAR).
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Effective annual interest rate - explained
The EAR refers to the interest paid back in real terms. This can be interest on credit cards, loans, or any other kind of debt. The EAR can be used to calculate your company's earnings on credit you extend to your clients or your real-term liability to creditors. It takes into account compounding to not be left with inaccurate cash flow projections.
The EAR formula is based on two variables - the nominal annual interest rate advertised and the number of periods (months) within which interest is compounded. The former is called "r" and the latter "m". The formula is as follows: EAR (i) = (1+r / m) x m −1
The EAR increases with the number of compounding periods. This means that eg quarterly compounding produces higher returns than compounding every six months, while monthly compounding makes more than quarterly.
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Example
Company A produces art prints. It needs to invest in new printing technology and wants to purchase a piece of equipment for GPB 4,000. Company A decides to get a loan to cover this expense rather than dipping into their savings account. Getting a loan from Bank X means paying interest of 10% compounded monthly. Bank Y has a compounding nominal interest rate of 10.1% (every six months). Using the formula, Company A would notice that, even though Bank Y has a slightly higher nominal interest rate, it has a lower EAR than Bank X because it compounds fewer times over the year.
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