Question

What is the difference between the effective annual rate and the annual percentage rate, and when should you use which?

Answer 1

Solution

APR can be defined as the intrest rate of a loan per period multiplied by the number of discounting or payment periods.On the other hand EAR (Effective annual rate) takes into the consideration ,the compounding of the periodic rates.The the relation between APR and EAR is given below

EAR =((1+APR/M)^M)-1

Where

M-number of compounding periods in a year

Therefore more the number of compoundng periods ,more it makes sense to use EAR as shown in below example

Suppose there are monthly payment with intrest rate of 1% per month

APR=1*12=12%

EAR=((1+.12/12)^12)-1

=0.126825

EAR=12.6825%

Thus there is a difference of .6825% which is significant in case of housing loans etc.Thus more the compounding periods,more significant is the EAR.Therefore in credit cards bills,Hopusing loan etc EAR is used