Question

In terms of savings, define the term ‘AER’ and describe how this concept is of use to savers when choosing between different savings products.

Answer 1

Different saving products may pay interest to investors single or multiple times in an year.

If the interest is given more than once within an year, there needs to be an effective rate.

AER stands for Annual Equivalent Rate.

For Instance, Lets take two cases.

Case 1: 100 dollars invested at 10% p.a. compounded yearly

This means the investor will get their 100 dollars after an year with interest of 10 dollars(10% of 100)

So, amount received = 100+10 = 110

Case 2: 100 dollars invested at 10% p.a. compounded half yearly

This means the interest will be received 2 times within an year (every 6 months)

after six months, interest = 10% of 100*0.5 = 5 (0.5 because of half year passed)

after 1 year, interest = 10% of 100*0.5 + 10% of 5*0.5 = 5+0.25

(additional interest on already received interest)

amount = 100+5+5.25 = 110.25

Hence, even if rate is 10% p.a. in both cases, no. of compoundings yield different interests. Since 10% in both cases cant be compared directly, therefore, EAR has to come in to know the effective rate as a standard benchmark to compare these rates.

For example, in case 1: EAR= 10%

in case 2: EAR= 10.25%