Skip to content
× FreshBooks App Logo
FreshBooks
Official App
Free - Google Play
Get it
You're currently on our UK site. Select your regional site here:
6 Min. Read

What Is the Effective Annual Rate(EAR) & How to Calculate It

What Is the Effective Annual Rate(EAR) & How to Calculate It

Have you ever wondered how to calculate the effective annual rate on a loan or investment? You’re not alone. Many people don’t know that there is an easier way to figure out what your return on an investment will be. It doesn't involve complicated formulas.

The effective annual rate (EAR) is an interest rate that takes into account the effect of compounding over multiple periods. It is used in finance and banking as well as in some consumer loans such as mortgages and car loans. We’ll show you how it works so you can understand your financial situation better than ever before!

Here’s What We’ll Cover:

What Is the Difference between Annual Percentage Rate and Effective Rates?

How to Calculate Effective Annual Rate (EAR)

Is a Higher Effective Annual Rate Better?

What Are the 2 Different Types of Interest Rates?

Relevance and Uses of Effective Annual Rate Formula

What Is the Best Investing Software?

Key Takeaways

What Is the Difference between Annual Percentage Rate and Effective Rates?

The simple annual interest rate is the rate that would be paid if the compounding took place only once per year on a given principal. This makes sense because many loans are compounded annually.

The effective interest rate is one that takes into account how often your money compounds in a year for an investment or loan. If you borrow money, the effective annual rate is usually higher than if you had only compounded the item annually. The more often your interest compounds, the greater your interest payments will be each year.

How to Calculate Effective Annual Rate (EAR)

There are many ways to calculate EAR. We’ll use Excel as an example. You’ll need a spreadsheet program like Excel to perform this calculation if you want to do it yourself, but we’ll also provide the equation so you can use it.

  1. Choose your 12-month period. If you were trying to figure out what the EAR would be for a six month investment, you would choose six months. If it were a three month investment, you’d choose three months. The length of your 12-month period will determine the number of compounding periods per year for your EAR calculation.
  2. Determine the interest rate. Just like with any loan or investment, you need to know what the interest rate is. This is usually given as a percentage, such as 5%.
  3. Compute your annual compound interest rate. You will need to take your interest rate and convert it into a decimal or percentage that can be added to 1 (100%). You can use the excel formula for this.
  4. Add your annual compound interest rate to 1. This is the number you are multiplying your original principal by in order to get the new value of your principal at the end of one year with compounding.
  5. Determine the number of times your interest compounds per year. In order to calculate this number, you simply divide your 12-month period into the number of compounding periods that you have (i.e., monthly compounding, weekly, daily or continuously compounded).

Is a Higher Effective Annual Rate Better?

A higher effective annual interest rate is better for an investment or loan. If you are saving up to buy something, you will have greater value at the end of your 12-month period if you earn a high effective annual rate on your money. This can be used in conjunction with how much more it will cost to pay back a loan over time if you have a high effective annual rate.

Understanding how the effective annual rate is calculated makes it easy to determine what your return on an investment will be. This can help you make better decisions when deciding where to put your money or when determining if taking out a loan is worth it.

What Are the 2 Different Types of Interest Rates?

The different types of interest rates are the simple annual interest rate and the effective annual interest rate. The simple annual interest rate is the one that would be given to you if it were compounded once per year, while the effective annual rate accounts for how many times the money in an account compounds per year. The more often your money compounding, the more returns you will get on your investment.

Relevance and Uses of Effective Annual Rate Formula

The effective rate is used to determine the total interest that will be paid on a loan or investment over a given time period. In order to calculate the effective annual rate, you need to know how often your money compounds and what the simple interest rate is. This can be useful for figuring out what your money will grow into after a number of years and how much it will cost to repay a loan.

When you invest in the stock market, the effective annual rate of return is crucial information. It can be used to determine how long it takes for your investment to double. It also tells what kind of gains you can get on your money over time. For example, if someone invests $100 at an effective annual rate of 10%, they will end up with $110 at the end of that time period. This is an overall ROI of 10%.

What Is the Best Investing Software?

The most popular software for tracking investments is Quicken. It allows you to calculate effective annual rates, as well as many other things regarding your finances.

A good investing software allows you to see graphically where your money is going and how much of a return you are getting on your investments. It should track multiple financial products. This allows for a better understanding of your finances and can help you to be more effective with where you invest the next time.

Here are 3 of the most popular investing software platforms:

  1. Quicken. Quick is quality software and is probably the most popular investing software around. While it's pricey, you get what you pay for. It has a ton of excellent features. It also comes with an annual rate calculator. 
  2. Mint. This is another great investing software that can help you keep track of your finances. It has several features that are catered specifically to the needs of those in debt, which makes it more appealing if you are trying to get yourself out of debt.
  3. EveryDollar. This is a budgeting software that focuses on ease of use. It has a great interface, and it's free!

Key Takeaways

In conclusion, an effective annual rate is simple to understand and calculate if you know how to do it properly. Effective annual rate is used in a variety of ways and has many implications for your money. It is important to know that the higher the effective annual rate, the more money you will make out of that investment or loan. This can help you make better decisions and save up more money in less time!


Did you enjoy reading this guide? Head over to our resource hub for more great content!


RELATED ARTICLES