What is an Effective Annual Interest Rate? Small Businesses Can Learn All About It
You can't be a successful business without an understanding of interest rates. But they're not always easy to understand because there's so much confusing financial jargon and acronyms floating around out there these days, which is why we want you to learn how the EAR works before it becomes too important for your company. In this blog, we're going to attempt to illuminate some of these points for you!
What is an annual interest rate?
"An annual interest rate is the annual cost of borrowing or lending money. It's often expressed as a percentage." - Investopedia
Basically, how much you pay every year for the amount that you have borrowed.
Annual interest rates are annualized, meaning that they calculate the annual amount of money a lender will receive for lending out their money at an annual percentage rate (APR).
This can also be referred to as the nominal interest rate.
What is the difference between the annual interest rate and the effective annual interest rate (EAR)?
The effective annual interest rate (EAR) is the annual interest rate but taking into account the effect of compounding over the course of the year.
This means that the effective interest rate is higher than the nominal interest rate a more accurate representation of annual interest.
How is the effective annual interest rate calculated?
Although you can find automated calculators online, it's important to understand the formula and how it works.
You'll need a few variables:
Nominal annual interest rate = i
The number of compounding periods (usually measured in months) = m
Once these are defined, the formula looks like this:
EAR = (1+r / m) x m −1
The higher the number of compounding periods, the higher the effective annual interest rate is, e.g. compounding on a monthly basis will have a higher annual percentage rate than compounding on a quarterly basis as the number of compounding periods in the year is higher.