In: Finance
Annual Percentage Rate also called nominal rate does not include
the affects of compounding. It infact represents simple interest
rate. This rate is quoted by banks for deposits. Auto loans and
mortgage loans are represented through APR.
If monthly rate = 1% . Then APR = Monthly Rate * Number of Months
in year = 1%* 12 = 12%
EAR is effective annual rate which takes into consideration the
number of compounding in the period . It represents compound
interest rate . It is used in credit card repayment calculation.
EAR is always equal or greater than APR.
If monthly rate = 1%, then EAR =(+ monthly rate)^n-1=(1+1%)^12-1
=12.68%
EAR is more relevant than APR in decision making because it takes
into consideration the number of compounding . With same APR if
number of compounding increases then the Future Value of the amount
will increase . Semi annual compounding, Quarterly compounding or
monthly compounding will have higher EAR but same APR. The actual
Present value of future payment cannot be determined by APR.
EAR method is better to evaluate different loan options, mortgage
loans, savings plan option because it takes into consideration the
number of compounding and helps to plan better.