Question

Which interest rate is more attractive to an investor, 12% per year with annual compounding, or 11.5% per year with monthly compounding?

Answer 1

Effective annual interest rate can be compute to compare different investment proposals.

Formula for effective interest rate is:

EAR = (1+i/n) ⁿ – 1

EAR = Effective interest rate

i = Stated interest rate

n = No. of compounding periods in a year

Computation of EAR for 12 % compounding annually,

EAR = (1+0.12/1)¹ – 1 = (1 + 0.12) – 1 = 1.12 -1 = 12 %

Computation of EAR for 11.5 % compounding monthly,

EAR = (1+0.115/12)¹² – 1

        = (1+0.009583333333333)¹² – 1

        = (1.009583333333333)¹² – 1

        = 1.12125932813797 – 1

        = 0.12125932813797 or 12.13 %

11.5 % monthly compounding is more attractive for investors as its EAR is higher than that of 12 % annually compounding.