The cost of money with a loan is stated as an interest rate or an annual percentage rate. Most loans and savings accounts feature compound interest, which also changes the interest rate over the term of the loan or time that money is deposited in savings. According to CNNMoney.com, the effective annual rate is "an annual measure of the time value of money that fully reflects the effects of compounding."
Annual Percentage Rate
The annual percentage rate (APR) for a loan or a savings account or other investment is expressed as a simple interest number that reflects the return on money or the rate that you will pay for the entire year. If you place $1,000 in an account that pays 3 percent APR and pays simple interest, you would earn $30 for the year, or 3 percent of the $1,000 balance.
Effective Annual Rate
The effective annual rate for a loan or account is often quoted when the interest is compounded, or added more often than once a year. Some accounts compound interest monthly, while others compound interest daily. The effective annual rate is quoted with the APR for an account or loan, and is generally higher than the specified APR.
Example: Effective Annual Rate
If you invest money at a 6 percent APR, and the interest rate is compounded monthly, the APR is divided by the number of compounding periods per year -- in this case, 12. The result of this calculation is that 6 percent APR translates to 0.5 percent per month. The first month, a $1,000 investment would earn $5, leaving a $1,005 balance in the account. The next month, the 0.5 percent interest is figured on the $1,005 balance, and would be $5.03 per month. By the end of the year, the original investment would gain a total of $61.68 in interest, for an effective annual rate of 6.168 percent.
Loan Rates and Comparisons
Loan rates take into account different factors concerning effective annual rate, including the compounding periods as well as any advance interest or points that the borrower must pay to secure the loan. Because of these differences, it is possible for two loans with 6 percent APR to have considerably different effective annual rates. Banks publish the effective annual rate to allow a level, fair comparison between different financial products.
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