Question

What is the difference between EAR (effective annual rate) and APR (annualized percentage rate)? Which one does a better job of measuring return? Give an example that illustrates your reasoning.

Answer 1

EAR (Effective annual rate) is nothing but the Compound Interest method of calculating interest whereas APR(annualized percentage rate) is Simple Interest.

EAR considers the effects of comounding Interest and it is generally used in evaluating the Loans that compounds at regular interval, such as Monthly, Quarterly. Suppose a loan which is Charging 1% interest per month. So according to EAR Yearly interest will be,

EAR = {(1+Perodic rate)^periods} - 1

EAR = {(1+0.01)^12} - 1

EAR = 12.68%

whereas APR represents simple interest of a particular period reffering the periodic Interest rate of a loan multiply by no. of periods. Suppose the same example above, loan which is Charging 1% interest per month. So according to APR Yearly interest will be,

APR = Interest Rate * Periods

APR = 1% * 12

APR = 12%

Hence a same Interest rate loan when calculated using EAR is higher then calculated by APR. This is because of the Compounding Concept which is used in calculating EAR. In EAR we charge Interest on Interest which effictivly increases the rate.

Hence if we have a loan with same Interest rate calculated in EAR and APR, we should always prefer APR because of lower rate.