Effective Annual Rate (EAR)
The effective interest rate, effective annual interest rate, annual equivalent rate (AER) or simply effective rate is the interest rate on a loan or financial product restated from the nominal interest rate as the interest rate with annual compound interest payable in financial obligation.
It is employed to compare the annual interest between loans with various compounding terms (daily, monthly, annually, or other). The effective interest rate differs in two significant respects from the annual percentage rate .
the effective interest rate by and large does not incorporate one-time charges such as front-end fees;
the effective interest rate is (by and large) not outlined by legal or regulatory authorities (as APR is in various jurisdictions).
By contrast, the effective APR is employed as a legal term, where front-fees and other costs could be included, as outlined by local law.
The effective interest rate is computed as if compounded annually. The effective rate is computed in the following way, where r is the effective annual rate, i the nominal rate, and n the number of compounding periods per year. For illustration, 12 for monthly compounding:
For illustration, a nominal interest rate of 7% compounded monthly is equivalent to an effective interest rate of 6.17%. 7% compounded monthly is credited as 7%/12 = 0.006 every month. After a year, initial capital will be increased by the factor (1 + 0.006)12 ≈ 1.0618.
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