Question

The R&M Bank has offered you the choice between two investment accounts: #1 pays interest at a rate of 12% compounded semi-annually #2 pays interest at a rate of 11% compounded monthly Which investment account do you prefer and why?

a) #2 highest effective rate

b) #1 12% is greater than 11%

c) #1 highest effective rate

d) #2 greater compounding frequency

Answer 1

Option 1:

APR = interest rate = 12%

n = 2 compoundings

Effective Annual rate can be calculated using the below formula

EAR = [1+(APR/n)]^n - 1

= [1 + (12%/2)]^2 - 1

= 1.1236 - 1

= 0.1236

= 12.36%

Option 2:

APR = interest rate = 11%

n = 12 compoundings

Effective Annual rate can be calculated using the below formula

EAR = [1+(APR/n)]^n - 1

= [1 + (11%/12)]^12 - 1

= 1.11571888 - 1

= 0.11571888

= 11.57%

Option C is correct

The best option is #1 since EAR of first option (12.36%) greater than EAR of second option (11.57%)